The financial markets context
The financial markets context

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The financial markets context

1 The market context

There is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Markets Hypothesis.

(Jensen, 1978)

I'd be a bum on the streets with a tin cup if the markets were efficient.

(Warren Buffett, attrib.)

Sell in May and go away.

(Old London Stock Exchange adage)

In this unit we examine a key question in finance.

  • How do the financial markets match providers with users, and how efficiently does the market determine prices?

The financial markets perform much the same function as the markets for other goods and services. They bring large numbers of buyers and sellers together, thus relieving each party of the need for a potentially long and expensive search for a counterpart with exactly equal but opposite needs to his or her own. The existence of such a market improves price transparency, encourages competition and improves efficiency generally.

But the financial markets can also be notoriously volatile. The stock market is possibly the most volatile of them all. This is after all the place where, depending on skill or on luck, investors either ‘make a killing’ or ‘lose their shirts’. But which does it depend on – skill or luck? Or does it depend on a mixture of the two?

A fair return on investment is one that offers the investor just the right level of compensation for the expected risk of the investment (in addition to the time preference rate and an adjustment for expected inflation). But why should it matter whether market prices for investments in fact offer fair returns? Could we argue that the pricing of investments is a zero-sum game in which one player's loss is another's gain? For every investor who loses by buying at the top of the market and selling at the bottom, there must be another who profits by doing the opposite.So can we argue that if a particular investment offers either an excessive or an inadequate return, total income and wealth are neither increased nor reduced but merely redistributed among the market participants?

On the other hand, if it could be shown that markets do price investments fairly, this would have genuinely radical consequences. It would mean that all the time and effort expended by investors on trying to ‘pick winners’ (that is, identify investments that pay excess returns) would be so much time and effort wasted. The converse argument would apply to organisations’ efforts to spot windows of opportunity to finance their operations when funds are apparently cheap, because such cheapness would be in fact illusory. The rate demanded by the market would be a fair one in relation to the risks involved.

Is it possible, through the exercise of skill or experience, to predict the movement of share prices in such a way that excess returns can be earned not just occasionally but consistently?

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