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Stock valuation and the efficiency of the markets
Beginner Stock Market Investing, Stock Market Investing Advice, Stock Valuation Comments Off
An investor like yourself uses stock valuation techniques and methods in an attempt to identify stocks that have been mispriced by the market. If the stock is, in your estimation, overvalued, you would sell and conversely, if your estimation shows an undervaluation, you would buy. The object of the exercise is to earn a return for yourself that is higher than what would be normal or, in investing in terminology, you are attempting to consistently beat the market. Market efficiency concerns itself with this possibility because, in a highly efficient market, it may be difficult to achieve this consistently or predictably.
Academics often categorize different types of market efficiency depending on the kind of information that is available to investors. Markets are considered to be strong form efficient when it is not possible to returns above normal on a consistent basis. Semi-strong form efficient markets are defined as markets where above normal returns cannot be consistently achieved with only the use of public information. The third category is weak form efficient markets where above normal returns cannot be earned consistently with only the use of historical data such as prices and volumes.
These academic distinctions are not particularly relevant to normal investors and what matters is only the relative efficiency of the market as far as you are concerned. For instance, there are a number of professional investors who measure the efficiency of markets by the speed of reaction to news and it does not matter how accurate the reaction is. What is important is that market efficiency or inefficiency should create opportunities for you to profit from mispricing. This whole approach consists therefore of trying to predict how the mispricing will change over a period of time and when corrections will happen.
An important argument in favor of the efficiency of the market runs thus. If an investor discovers a market inefficiency in the form of an over valuation or an undervaluation, he would naturally try to take as much advantage as possible. As a consequence of his action, supply and demand will adjust to the inefficiency ceases to exist. As an example, let us assume that you can buy chocolate bars for $.90 apiece and sell them for one dollar a piece. You would naturally try and buy and sell as many bars as possible. On the supply side, over a period of time, the price will rise while on the demand side, prices will fall. Over a period of time the price differential and your profit will vanish. This would suggest that market inefficiency exist briefly and you have a narrow window of opportunity in which to take advantage.
On the other hand, the argument against market efficiency is that if the market is truly efficient, research would be an additional cost and actually depress returns. If every market participant abandoned research altogether, stock prices will soon diverge from their fair valuations and research would become profitable again as profit opportunities emerge. The conclusion seems to be that, on balance, the markets are just inefficient enough to provide opportunities for higher than normal returns.