Factors of Market Efficiency and CAPM

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Factors of Market Efficiency and CAPM
The notion of an efficient stock market has come under criticism in recent years. (Stock Market image by Paul Heasman from Fotolia.com)

The efficient market hypothesis is a way of looking at stock prices. It is based on the notion that you cannot get superior results from your investments compared to the next investor. The Capital Asset Pricing Model (CAPM), developed by William Sharpe, posits that returns on stocks are based on how risky they are, with the relevant risk being market volatility. This model gives a framework for estimating what the return on a stock should be in a given market environment, considering that the market is efficient. The efficient market hypothesis has attracted a lot of criticism following the financial crisis and great recession of the late 2000s.

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Efficient Market Hypothesis

The efficient market hypothesis developed by Eugene Fama states that stock prices reflect information that all investors know. This implies that investors cannot get superior returns considering that stock prices already factor in all the relevant information. There are three forms of market efficiency. In a strong efficient market, all information, both public and private, about the stock is reflected in its price. In a semi-strong efficient market, all publicly available information is reflected in a stock’s price. In a weak efficient market, all past information is factored into the stock price.

Capital Asset Pricing Model

The capital asset pricing model holds that a stock gets a return based on a risk-free rate, as well as its market risk. The CAPM considers risk to be the market volatility of the stock. The term beta is used to indicate a stock’s volatility in this model. The more volatile the stock, the higher its beta. In this model, an investor can diversify away the risk of an individual stock by holding a portfolio of diverse stocks. However, the portfolio is always subject to market volatility, which cannot be diversified away, so that is the relevant risk for which the individual is rewarded, in excess of the risk-free rate of return.

Market Inefficiencies

The theory of market efficiency has come under heavy criticism following the financial crisis of 2007. There have been wild swings in stock prices and they do not reflect all known information about a stock. Moreover, real returns on a stock do not always reflect what the CAPM says they should be. Stocks have generated returns that are higher or lower than what the CAPM model says they should generate in an efficient market, given their risk profiles.

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