Product Markets

Product Markets

A balanced discussion of market efficiency must include the fact that there are a num- ber of studies whose results are not consistent with the efficient market hypothesis. For example, there is evidence that stocks sometimes overreact to information, contradicting the assumption that new information is accurately impounded into market prices. Other so-called market anomalies (apparent violations of market efficiency) include the small firm effect, which seems to indicate that small firms’ shares outperform large firms’ shares on a risk-adjusted basis, and the January effect, which is named for the concentration of strong stock returns during the first few days of January. The existence of these anoma- lies led Professor Andrew Lo of MIT to propose the adaptive markets hypothesis (Lo, 2004, 2005), which attempts to reconcile anomalies to the idea of efficient markets. Lo’s work is based on classical economics but also borrows from evolution and neuroscience to suggest that tolerances, regulations, and objectives shift over time resulting in mar- ket behaviors that appear to be inconsistent with market efficiency. This theory is in its infancy, but it reinforces the point that market efficiency is not without its mysteries and well-documented exceptions that economists are still attempting to explain.

The lesson of efficient markets is that it is extremely difficult to earn abnormally high returns from investing using publicly available information. Many students find this result discouraging because it dashes their hopes of making an easy fortune in the stock market. There is, however, encouraging news: At any moment in time actively traded financial securities are likely to be fairly priced, so you may reasonably expect to earn a fair return (fair meaning a return commensurate with the risk you are taking) on your money. In other words, you don’t have to be a genius to do quite well with your savings.

Applying the lesson of efficient markets to corporations is straightforward. Corporate managers will rarely enhance the wealth of shareholders (the key decision criterion for managers) through financial market transactions in efficient markets. In many ways, this is good news for corporate officers. Efficient markets imply that prices reflect available information, or that prices are fair. When companies issue and sell securities, on average, they receive a fair price for those securities. Therefore, managers can concern themselves primarily with how the funds will be used, not with how the funds were obtained. Efficient markets make the job of financial managers simpler. Moreover, fair and efficient financial markets, such as those with prohibitions against insider trading, encourage investors to participate and thereby increase the pool of available funds. A larger supply of investment dollars translates into a lower price for those dollars, so corporate managers benefit in a second way: In efficient markets, they gain access to fairly priced and relatively inexpen- sive funds.