Stock market efficiency

Stock market efficiency refers to reactions by share prices following certain events that are relevant to the company in question. This information can come in several forms and is not exclusively related to actual events that have occurred. The stock price can be influenced by how investors perceive certain information, even if the information is not valid and purely based on a rumour.

The efficient market hypothesis was formulated professor Eugene Farma and argues that stock prices are fully reflective of all information available about that particular stock and therefore no individual investor holds any advantage over fellow investors due to the fact that the information concerning the stock is available to all. However, this theory is widely disputed. Real life examples, non more striking that Warren Buffet's continued success in trading, suggest that the stock market indeed can be beaten. One must consider how a market can be random when individuals such as Mr Buffet continue to profit from trading.

Consideration into the reactions of share prices following significant news should be taken. One would assume that 'good news' related to a certain company would reflect positively on the the value of the share prices. However, there are several examples where the opposite has occurred. Recently the Ford Motor Group announced a profit of $6.6 billion for 2010, it's largest recorded profit in over 10 years. How did this positive news effect the share price? You would be forgiven for assuming that such impressive profit figures would surely result in positively in the share price - this was not the case. Shares in ford fell by more then 12%.

This seemingly unusual occurrence can be explained by considering the stock market as a leading economic indicator i.e. stock prices reflect what investors think will happen rather than what has actually already happened. In this case investors had predicted that Ford was going to achieve impressive profit levels and therefore the share price had already been influenced by this assumption. Despite record levels of profit being achieved, investors had predicted even better performance and as a result the share price was over valued. This meant that in order for the share price to remain the same or even increase, even better profit figures would have had to been achieved to correspond with the initial assumptions of the investors. The reduction in share price following the news is an example of 'market correction', and reiterates the fact that the previous higher share price was indeed too high.

The fact that share prices can react negatively following positive news poses the question of whether or not investing in the stock market is in fact merely a game of chance. Kendal argues that prices change in random fashion with no systematic link being apparent between one price movement and the next ones. This ties in with the concept of 'Random Walks', whereby analysis of past information bears no relevance to upcoming events, similar to a drunk man stumbling along the road not knowing which way to turn. A passer by would not be able to predict the drunk man's next steps purely by looking at his previous ones.

 Personally I think the continued success of certain traders such as Warren Buffet who have beaten the market and made significant profits from investments is enough evidence to suggest that analysing certain information can indeed allow you to make wise, successful investment decisions. Warren Buffet, who attributes much of his success to learning from Benjamin Graham, is a pioneer of value investing and continues to implement his strategy of buying undervalued shares. Surely anyone who succeeds so often and over such a long period of time is proof that performance in the stock market is not random? I think so.