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AswathDamodaran1MarketEfficiency:DefinitionsandTestsAswathDamodaran2Whymarketefficiencymatters..OQuestionofwhethermarketsareefficient,andifnot,wheretheinefficiencieslie,iscentraltoinvestmentvaluation.OIfmarketsare,infact,efficient,themarketpriceisthebestestimateofvalue,andtheprocessofvaluationbecomesoneofjustifyingthemarketprice.OIfmarketsarenotefficient,themarketpricemaydeviatefromthetruevalue,andtheprocessofvaluationisdirectedtowardsobtainingareasonableestimateofthisvalue.OMarket'inefficiencies'canprovidethebasisforscreeningtheuniverseofstockstocomeupwithasub-samplethatismorelikelytohaveundervaluedstocksOSavestimefortheanalystOIncreasestheoddssignificantlyoffindingunderandovervaluedstocks.AswathDamodaran3Whatisanefficientmarket?OEfficientmarketisonewherethemarketpriceisanunbiasedestimateofthetruevalueoftheinvestment.OImplicitinthisderivationareseveralkeyconcepts-OMarketefficiencydoesnotrequirethatthemarketpricebeequaltotruevalueateverypointintime.Allitrequiresisthaterrorsinthemarketpricebeunbiased,i.e.,thatpricescanbegreaterthanorlessthantruevalue,aslongasthesedeviationsarerandom.Randomnessimpliesthatthereisanequalchancethatstocksareunderorovervaluedatanypointintime.AswathDamodaran4ImplicationsofRandomnessOThefactthatthedeviationsfromtruevaluearerandomimplies,inaroughsense,thatthereisanequalchancethatstocksareunderorovervaluedatanypointintime,andthatthesedeviationsareuncorrelatedwithanyobservablevariable.Forinstance,inanefficientmarket,stockswithlowerPEratiosshouldbenomoreorlesslikelytoundervaluedthanstockswithhighPEratios.QIfthedeviationsofmarketpricefromtruevaluearerandom,itfollowsthatnogroupofinvestorsshouldbeabletoconsistentlyfindunderorovervaluedstocksusinganyinvestmentstrategy.AswathDamodaran5DefinitionsofMarketEfficiencyODefinitionsofmarketefficiencyhavetobespecificnotonlyaboutthemarketthatisbeingconsideredbutalsotheinvestorgroupthatiscovered.Itisextremelyunlikelythatallmarketsareefficienttoallinvestors,butitisentirelypossiblethataparticularmarket(forinstance,theNewYorkStockExchange)isefficientwithrespecttotheaverageinvestor.Itispossiblethatsomemarketsareefficientwhileothersarenot,andthatamarketisefficientwithrespecttosomeinvestorsandnottoothers.Thisisadirectconsequenceofdifferentialtaxratesandtransactionscosts,whichconferadvantagesonsomeinvestorsrelativetoothers.ODefinitionsofmarketefficiencyarealsolinkedupwithassumptionsaboutwhatinformationisavailabletoinvestorsandreflectedintheprice.Forinstance,astrictdefinitionofmarketefficiencythatassumesthatallinformation,publicaswellasprivate,isreflectedinmarketpriceswouldimplythateveninvestorswithpreciseinsideinformationwillbeunabletobeatthemarket.AswathDamodaran6InformationandMarketEfficiencyQUnderweakformefficiency,thecurrentpricereflectstheinformationcontainedinallpastprices,suggestingthatchartsandtechnicalanalysesthatusepastpricesalonewouldnotbeusefulinfindingundervaluedstocks.QUndersemi-strongformefficiency,thecurrentpricereflectstheinformationcontainednotonlyinpastpricesbutallpublicinformation(includingfinancialstatementsandnewsreports)andnoapproachthatwaspredicatedonusingandmassagingthisinformationwouldbeusefulinfindingundervaluedstocks.QUnderstrongformefficiency,thecurrentpricereflectsallinformation,publicaswellasprivate,andnoinvestorswillbeabletoconsistentlyfindundervaluedstocks.AswathDamodaran7ImplicationsofMarketEfficiencyONogroupofinvestorsshouldbeabletoconsistentlybeatthemarketusingacommoninvestmentstrategy.OAnefficientmarketwouldalsocarryverynegativeimplicationsformanyinvestmentstrategiesandactionsthataretakenforgranted-(a)Inanefficientmarket,equityresearchandvaluationwouldbeacostlytaskthatprovidednobenefits.Theoddsoffindinganundervaluedstockshouldberandom(50/50).Atbest,thebenefitsfrominformationcollectionandequityresearchwouldcoverthecostsofdoingtheresearch.(b)Inanefficientmarket,astrategyofrandomlydiversifyingacrossstocksorindexingtothemarket,carryinglittleornoinformationcostandminimalexecutioncosts,wouldbesuperiortoanyotherstrategy,thatcreatedlargerinformationandexecutioncosts.Therewouldbenovalueaddedbyportfoliomanagersandinvestmentstrategists.(c)Inanefficientmarket,astrategyofminimizingtrading,i.e.,creatingaportfolioandnottradingunlesscashwasneeded,wouldbesuperiortoastrategythatrequiredfrequenttrading.AswathDamodaran8Whatmarketefficiencydoesnotimply..QAnefficientmarketdoesnotimplythat-(a)stockpricescannotdeviatefromtruevalue;infact,therecanbelargedeviationsfromtruevalue.Thedeviationsdohavetoberandom.(b)noinvestorwill'beat'themarketinanytimeperiod.Tothecontrary,approximatelyhalfofallinvestors,priortotransactionscosts,shouldbeatthemarketinanyperiod.(c)nogroupofinvestorswillbeatthemarketinthelongterm.Giventhenumberofinvestorsinfinancialmarkets,thelawsofprobabilitywouldsuggestthatafairlylargenumberaregoingtobeatthemarketconsistentlyoverlongperiods,notbecauseoftheirinvestmentstrategiesbutbecausetheyarelucky.QInanefficientmarket,theexpectedreturnsfromanyinvestmentwillbeconsistentwiththeriskofthatinvestmentoverthelongterm,thoughtheremaybedeviatio