INEFFICIENCY OF FINANCIAL MARKETS
An inefficient market is a theory which states that the prices in the market of common stocks and securities similar to them are not usually priced accurately. It states that they have a habit of deviating from the true discounted value of cash flows in their future. In an inefficient market, some securities are sold at an over price or under price. This is to tell that there are investors who end up making excess returns while others may lose more than they intended to. If markets were efficient such cases of opportunities and threats would never be observed for long periods since the prices in the market would be quick to match the value attached to security before it changed (Stiglitz, 2015). Lack of empirical support for the CAPM and discovery of the existence of various market abnormalities is a good source of enough evidence that financial markets are inefficient.
The capital asset pricing model is an ideal means of portraying the means through which financial markets price various securities as a means of being able to determine the returns expected for capital investments. The pricing model can come up with a methodology which assists in quantifying risks and being able to translate them into estimates of returns expected on equities. Numerous empirical tests on CAPM have been carried out. They examine the past as a means of determining the extent betas and stock returns have gone in line with the prediction made on securities. Empirical studies have been able to conclude that as much as the beta is related to past returns, the existence of close relations within total risk and systematic risks causes difficulty while distinguishing their empirical effects (Baltes, 2015).Also, fewer beta securities get to earn higher returns than the prediction made by CAPM while stocks based on high beta get to earn less than what is predicted. Shortcomings in the CAPM explain the phenomenon. The empirical tests do not show any support for CAPM and its major implications.
Market anomalies are instances when a group of securities have their performance going in contrary to how efficient markets are supposed to perform. They are good proof that financial markets are inefficient.
Stocks belonging to companies which have a large price to book ratios often do better as compared to stocks which possess less price to book ratios. The result is not dependent on the beta of a stock which makes it not dependent on systematic risks. The result may be elaborated by the fact that companies which possess low price to book ratios give investors high expectations for rapid growth. However, as companies become bigger, the rate of rapid growth declines. This means that the rate at which stock prices grow will be decreased as the price-earnings ratio goes down and the expectation of future growth goes down. With a drop in price-earnings ratio, the returns also drop. Stocks which have a high book-to-market ratio do not decline in bear markets because less risk is involved whenever a market value of a company is closer to the book value.
Earning announcements is an anomaly which may have variable effects on the prices of stocks. There are times when the prices of stocks go up till the announcements for earnings, and then they go down upon the news. They may also go down before announcements take place if no positive expectations exist. The expectations are usually in alignment with reports from analysts and the forecast they place towards earnings in the future. Most of the websites make the expected earnings. In cases where the actual reported earnings tend to be different from what was expected, a great effect on stock price may be affected for a while. According to Deyshappriya (2014), the greater the earnings surprise, the more the effect on the stock prices. Positive stock surprises may cause an increase in the price for approximately two months, following the announcement. Negative surprises, on the other hand, may cause a decrease in price for approximately the same period. This study shows that watching announcements may lead to abnormal returns and changes in price are not as quick as an efficient market hypothesis would put it.
The neglected firm effect is based on the observation that minor firms which are not fully covered by analysts often outperform a market. Since most of the firms which are neglected are small ones, this is a reflection of the fact that a great potential for growth exists among small firms. This means that the neglected firm effect may not be an actual representation of an effect which is independent. The effect may also come up because when small firms grow into larger firms, the level of coverage by analyst becomes high, the float for the stock goes up and this creates a chance for institutional investors to purchase the stock. Most of the institutional investors are hesitant to purchase stocks whose float is limited because a major buy or sell may be of relevant effect on the stock price.
Deyshappriya, N.R., 2014. An empirical investigation on stock market anomalies: The evidence from Colombo Stock Exchange in Sri Lanka. International Journal of Economics and Finance, 6(3), p.177.
Baltes, N., Dragoe, A.G.M. and Ardelean, D.I., 2015. Study regarding the assets evaluation of the financial market through the CAPM model. Studia Universitatis Vasile Goldis Arad, Seria Stiinte Economice, 24(3), pp.78-87.
Stiglitz, J.E. and Rosengard, J.K., 2015. Economics of the Public Sector: Fourth International Student Edition. WW Norton & Company.