Category: LOS – explain factors that affect a market’s efficiency

An active investment strategy tries to earn higher returns by identifying mispriced securities. Active investors believe that some securities are undervalued or overvalued and try to profit from these pricing errors.

A passive investment strategy does not try to beat the market. Instead, it focuses on holding a diversified portfolio for the long term, usually at a lower cost.

In efficient markets, passive strategies are often preferred because prices already reflect information. Active strategies may not generate enough extra return after considering costs.

Example:
Suppose an active fund gives a return of 13% in one year. A passive index fund gives a return of 12% in the same year.

However, the active fund charges 2% as management fees, while the index fund charges only 0.3%.

After costs:

Active fund return = 13% – 2% = 11%
Passive fund return = 12% – 0.3% = 11.7%

Even though the active fund performed better before costs, the passive fund gave a better return after costs.

This is why cost plays an important role in market efficiency and investment strategy.

Arbitrage means buying an asset in one market at a lower price and selling it in another market at a higher price to earn a riskless profit.

Arbitrage helps improve market efficiency because it removes pricing differences between markets.

Example:
Suppose the same stock is trading at ₹100 on Market A and ₹105 on Market B.

An arbitrageur can buy the stock at ₹100 in Market A and sell it at ₹105 in Market B.

Profit per share:

₹105 – ₹100 = ₹5

If the arbitrageur trades 1,000 shares, total profit will be:

₹5 × 1,000 = ₹5,000

As more traders do this, demand increases in Market A and selling pressure increases in Market B. Eventually, the prices move closer, and the price difference disappears.

So, arbitrage helps correct mispricing and makes markets more efficient.

In an efficient market, investors should not expect to earn superior returns without taking additional risk.

If one investment gives a higher expected return, it is usually because it carries higher risk. Market efficiency suggests that prices adjust in such a way that return and risk remain connected.

Example:
Suppose a government bond gives a return of 7% per year and a small company stock gives an expected return of 15% per year.

The higher return from the stock does not mean free profit. It may reflect higher business risk, price volatility, and uncertainty.

If the stock was offering 15% return with the same risk as the bond, many investors would buy it. This buying pressure would increase the stock price and reduce its expected return.

So, in efficient markets, higher returns usually come with higher risk.

In an efficient market, asset prices are influenced by investor expectations.

Investors form expectations about future cash flows, risk, growth, and required return. When new information arrives, these expectations change. Based on their revised views, some investors buy the asset while others sell it.

The market price is formed through this buying and selling process.

Example:
Suppose a stock is trading at ₹1,000. Investors expect the company to grow at 8% per year.

Now the company announces a new product launch, and investors believe that future growth may increase to 12% per year. Because of this higher growth expectation, more investors may start buying the stock.

As demand increases, the stock price may rise from ₹1,000 to ₹1,150.

This price change reflects the revised expectations of investors.

So, an efficient market continuously updates prices based on new expectations.

An efficient market does not mean the market is perfect.

In real life, markets are usually neither completely efficient nor completely inefficient. They often fall somewhere between these two extremes. Some securities may reflect information quickly, while others may adjust slowly.

Market efficiency depends on several factors such as:

1. Number of investors following the security
2. Availability of information
3. Trading volume
4. Liquidity
5. Transaction costs
6. Speed of information flow

Example:
A large company stock may be followed by 50 analysts and thousands of investors. If new information is released, the price may adjust very quickly.

But a small company stock may be followed by only 2 or 3 analysts. Since fewer investors track it, the price may take longer to adjust.

This means large and liquid markets are generally more efficient than small and less liquid markets.

In an efficient market, prices react mainly to unexpected information.

If investors already expect a particular result, that expectation may already be included in the asset price. Therefore, when the expected result is announced, the price may not move much.

But if the actual result is better or worse than expected, the price may change significantly.

Example:
Suppose investors expect a company to report a profit of ₹100 crore. Based on this expectation, the stock is already trading at ₹800.

Now there are three possible outcomes:

1. Company reports profit of ₹100 crore
   The stock price may not change much because the result was expected.
2. Company reports profit of ₹130 crore
   The stock price may rise because the profit is ₹30 crore higher than expected.
3. Company reports profit of ₹70 crore
   The stock price may fall because the profit is ₹30 crore lower than expected.

This shows that market prices respond more strongly to surprise information than expected information.

Financial disclosure means companies share important financial and business information with the public.

Good disclosure helps investors understand the value, risk, and performance of a company. When disclosure is clear and timely, prices are more likely to reflect true information.

Example:
Suppose a company has debt of ₹500 crore, but it clearly discloses this in its financial statements. Investors can include this risk while valuing the company.

If the stock was trading at ₹1,000, investors may revise the fair value to ₹900 after considering the debt risk.

But if the company hides important information, investors may make wrong decisions. This can lead to mispricing in the market.

So, proper financial disclosure improves fairness, transparency, and market efficiency.

In an efficient market, prices should adjust quickly when new information becomes available.

The speed of price adjustment depends on the market. In highly liquid markets, such as large company stocks, foreign exchange markets, or developed equity markets, prices may adjust within seconds or minutes.

If prices take too long to adjust, some traders may use that delay to earn profits. This means the market may not be fully efficient.

Example:
Suppose a company announces at 10:00 AM that it has received a large new contract worth ₹1,000 crore. Before the announcement, the stock price was ₹200.

If the market is efficient, investors will react quickly. The stock price may move to ₹230 or ₹240 within a short time.

But if the stock stays at ₹200 for several hours despite the good news, informed traders may buy the stock and profit when the price eventually rises.

This delay in price adjustment indicates market inefficiency.

Information availability means how easily investors can access important information about securities, companies, and markets.

When information is widely available, investors can analyze it and trade based on it. This helps prices adjust quickly and makes the market more efficient.

Example:
Suppose a company announces that its profit has increased from ₹100 crore to ₹130 crore.

If this information is publicly available to all investors, many investors may revise their valuation and start buying the stock. The stock price may rise from ₹800 to ₹900 quickly.

But if only a few investors get this information early, they may gain an unfair advantage. This reduces fairness and lowers market efficiency.

So, equal and timely access to information is important for an efficient market.

Information-acquisition cost is the cost incurred by investors to collect, study, and analyze information before making investment decisions.

This may include research reports, analyst services, data tools, financial models, and time spent on analysis.

If information costs are high, fewer investors may analyze securities. This can reduce market efficiency.

Example:
Suppose an investor spends ₹50,000 on research to identify an undervalued stock.

The investor buys the stock and earns a gross profit of ₹70,000.

Net profit after research cost:

₹70,000 – ₹50,000 = ₹20,000

In this case, the investor still earns a profit.

But if the gross profit was only ₹40,000, then:

₹40,000 – ₹50,000 = -₹10,000

The investor would lose money after considering information cost.

So, information must provide enough benefit to justify its cost.