Security prices accurately reflect available

information, and respond rapidly to new

information as soon as it becomes
available
Weak form efficiency: prices incorporate information
about past prices
Semi-strong form: incorporate all publicly available
information
Strong form: all information, including inside
information
Reasons to Think Markets Ought to
Be Efficient
Marginal investor determines prices
Smart money dominates trading
Survival of fittest
Reasons to Doubt these Reasons
Marginal investor: wealth matters
Smart money: matter of degree. Limits to arbitrage
theory
Survival of fittest: life cycle renews
Psychological Factors
Gambling behavior
Overconfidence
Slowness to make money, futility of career trying to
prove others of ones ability


Technical Analysis
Robert D. Edwards & John Magee, Technical Analysis
of Stock Trends, 1948.
Hand drawing of charts, judgmental interpretation of
patterns
Difficult to test success of technical analysis
Head & Shoulders Pattern
Initial advance attracts traders, upward
momentum. Smart money begins to distribute
stock, trying not to kill demand.
Eventually downturn, but smart money comes in
to support demand, manipulation. (left shoulder)
Upward momentum resumes, ends when smart
money has distributed all shares; market drops.
New traders try to exploit well-known tendency to
rally. New weak rally, right shoulder, then a
breakout. (Edwards & Magee)
Implications of Efficiency
Allocational efficiency
If markets are not allocationally efficient then
perhaps there is a ________________________
___________ in capital markets.







role for greater government
intervention
Possible rules changes to attempt to improve
allocational efficiency
Tax on trading activity
More taxes on short holding period returns
Changes in corporate compensation
Implications of Efficiency
Informational efficiency
If markets are not informationally efficient








Investors may not be able to trust that market
prices are up to date and investors should
then conduct their own research (or hire a
researcher) to validate the price.
Privileged groups of investors will be able to
consistently take advantage of the general
public.
Active strategies could outperform passive
strategies.
Relationships between forms of
the EMH
Notice that _______________________________
__________________ (but _____________)

Strong form efficiency would imply that
__________________________________________.
semi-strong efficiency implies weak
form efficiency holds NOT vice versa
both semi-strong and weak form efficiency hold