Capital market efficiencycurrent sense is not related to ‘efficient’ in the sense of having no specific risk (see
Chapter 7). It is unfortunate that the same word has become the standard term to
describe two different concepts.Why should capital markets be efficient?
Prices are set in capital markets by the forces of supply and demand. If the consensus
view of those active in the market is that the shares of a particular business are under-
priced, demand will force the price up.
In a secondary capital market such as the LSE, security prices are observed by large
numbers of people, many of them skilled and experienced, and nearly all of them
moved to do so by that great motivator – financial gain. Information on the business
comes to these observers in a variety of ways. From the business itself come financial
statements, press releases and leaks (deliberate or otherwise). Information on the in-
dustry and economy in which the business operates will also be germane to assessment
of the value of a particular security, and this will emerge from a variety of sources.
Where observers spot what they consider to be an irrational price, in the light of
their assessment of, say, future projected dividends, they tend to seek to take advant-
age of it or to advise others to do so. For example, an investment analyst employed by
a unit trust might assess the worth of a share in Tesco plc at £3.50 but note that the
current share price is £3.00. The analyst might then contact the investment manager to
advise the purchase of some of these shares on the basis that they are currently under-
priced and there are gains to be made. The increase in demand that some large-scale
buying would engender would tend to put up the price of the shares. Our analyst is
just one of a large number of pundits constantly comparing the market price of Tesco
shares with their own assessment of their worth. Most of these pundits will take action
themselves or cause it to be taken by those whom they advise if they spot some dis-
parity. The market price of the shares at all times represents the consensus view.
If people feel strongly that this price is irrational, they will take steps to gain from their
beliefs: the greater they perceive the irrationality to be, the more dramatic the steps
that they will take.Efficiency and the consensus: predicting American football results
- ask the audience or phone a friend
Efficiency has been interpreted by some people as requiring that there is at least one
person active in the market who has great knowledge, skill and judgement. This need
not be the case. Beaver (1998) points out that all that is needed for efficiency is many
observers with most having some rational perceptions even if their other perceptions
about the security are misguided. He argues that the misguided perceptions will be
random and probably not held by others. The rational perceptions, on the other hand,
will be common, perhaps not to all, but nonetheless to a large number of observers. As
the security price reflects a weighted averageof the perceptions of all of those active in
the market for that particular security, the misconceptions, because they are random,
will tend to cancel each other out and so have no overall effect on the price. The cor-
rect perceptions will not be random and so will not cancel each other and will there-
fore be reflected in the share price.
Beaver illustrates and supports this point with what is at first sight an irrelevant
account of some predictions of results (win, lose or draw) of American football games.