One of the most critical debates among investors regards the efficiency of the capital market with their objective aimed at determining whether the information provided in the market is reflected within the market at all times. The concept o capital market efficiency postulates that the stocks within the market are priced perfectly per the investment properties they possess and as such, all market participants have the full knowledge of their pricing. According to the proponents of capital market efficiency, there are no investors who are advantaged in predicting the returns that certain stock prices may yield since they do not possess information that is not possessed by other investors. Subsequently, no investor can out-profit the other noting that the stock prices only respond to the available information in the market.
Behavioral challenges in achieving efficiency
A widely held assumption in the efficient market hypothesis is the view that all market players are rational pricing stocks based on the expected future cash flow changes (Ross, Westerfield, Jaffe, & Jordan, 2016). However, behavioral finance attempts to explain how investors behave while struggling to make complex calculations with enormous information at their disposal. One behavioral challenge exhibited by market players is irrationality, where some investors tend to make decisions that are not sound often under the influence of emotions. Additionally, achieving efficiency is affected by the behavioral challenge in arbitrage where investors quickly acquire and sell foreign currencies in distinct markets aiming at profits that are substantially exceeding the transaction cost (Ross et al., 2016). Furthermore, the regret theory also explains behavioral challenges in achieving market efficiency where investors react emotionally after realizing they have made an error. Consequently, they avoid selling or buying a given stock to evade regretting a bad decision.
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Forms of market efficiency
Market efficiency is exhibited in three distinct forms. First, in the weak market efficiency, the current stock prices are in full reflection of the available security market data. Subsequently, it can be concluded that the products’ present value mirrors the information comprised of all previous prices. As such, the accurate analysis using previous prices are insignificant in investigating underestimating stocks.
In the semi-strong market efficiency, the information that is available publicly is incorporated in the stock prices. As such, the information is broader in comparison to the security price volume and data noting that it encompasses relevant information including news articles and company statement among other information (Ross et al., 2016).
Finally, in the strong form efficiency, no one is privy to insider information. Usually, the strength of the strong form market is founded because investors do not have information that can work to hint on the aggregate stock direction.
The implication of corporate finance
Market efficiencies have different implications for corporate finance. First, past prices as in the weak form efficiency do not have the predictive ability regarding the future direction of stock prices, thus becoming difficult to use technical analysis to gain positive risk-adjusted returns. Additionally, in the semi-strong efficiency, it proves difficult to achieve positive risk-adjusted gains on average (Ross et al., 2016). Finally, in the strong form efficiency, the lack of insider information makes it challenging to earn abnormal profits.
The real estate market
The real estate market can be argued to be an inefficient capital market. Various reasons can be given to explain why the market is not efficient. First, all the pertinent information is often not available. Additionally, the relevant information that is available within the real estate capital market is not reflected in the prices that are given. Furthermore, different “correct prices” can be given for the same property since such pricing depends on the preferences of the buyer and what the buyer intends to do with the property. Finally, it should be noted that buyers have other motives rather than prices that motivates them in purchasing a property.
Reference
Ross, S., Westerfield, R., Jaffe, J. & Jordan, B. (2016). Corporate finance (11th edition). New York, N.Y. McGraw-Hill Education.
