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A common feeling that besets consumers after making a significant purchase is that of 'buyer's remorse'. Whilst this may be the regret of giving into impulse and exchanging our savings for something that we might have been able to do without, often it is a fear that we have not receive good value for our money. "Did I pay too much?" or "Did I make a good decision?" are concerns that are likely to proceed an acquisition. And this fear is mainly due to uncertainty or concern whether or not the seller has disclosed all of the important information needed to make a good decision.
Whilst this may be a real fear when engaging with consumer markets (think second-hand car market, etc), those seeking to 'sell' capital opportunities in their business (i.e. shares or bonds) do not want the same kind of fear to pervade financial markets. This is because the more worried investors are in regard to the integrity of stock or bond markets, the less reluctant buyers become and the more expensive raising capital will be. This leads to an incentive for companies to be as transparent as possible, and which is supported by regulatory encouragement (to help protect all companies against the systemic nature of corporate scandal and misconduct).
To this end, financial markets that are backed by strong rule of law and ethical codes are likely to have high levels of information transfer from insiders to investors. This is usually done through financial reporting and mandatory market announcements, whereby significant information is disclosed to market participants in a timely fashion. Thus, if there are enough eyes on a company and its performance (i.e. research analysts, stock traders, etc) than all such information should be well incorporated into transaction decisions and stock and bond prices. This is likely to result in such prices being close to fair value.
This is the basis for the efficient market hypothesis (EMH), which posits that markets with highly accessible corporate information will efficiently discover fair prices. This relies upon a quantum of willing buyers and sellers, all of which analyse the available information and reach their own, individual conclusions about reasonable price. Each will approach the market with their conclusions, some of which will might overvalue the share or bond and some of which will undervalue it. But on aggregate, the activity of all of these investors and their assessed values will see the final trading price of the security be close to its 'true' value.
Now, not all markets are created equal and the EMH acknowledges this by breaking down markets into three categories:
- Weak form - This is a market in which the only available information for investors is that of past market data (e.g. past prices, volumes). Thus, there is no analysis of security fundamentals.
- Semi-strong form - This is a market in which the only available information for investors is that of past market data and publicly released information. This allows for the additional analysis of company fundamentals attained through market disclosures and other reporting.
- Strong form - This is a market that has all information available to investors, including insider information. This allow for the full analysis of all significant information.
One proposition of EMH is that markets are efficient and realised prices are fair. This means that it is not possible for investors to consistently earn excess returns beyond the average as any change in price must only be based on new information; information that is random (sometimes good news, sometimes bad news) and unpredictable (no-one knows when or what the news will be). If investors did know what the next piece of information will be, everyone will know this and everyone will reshape their assessments accordingly.
Of course, there are always exceptions to any rule and there are plenty of studies that have shown some discrepancies in the notion of efficient markets. One reason for this may be that investors may exhibit biased or 'irrational' decision making (i.e. decisions based on factors other than price and return) as individuals and as groups. Another reason may be due to holes in transparent disclosures whereby information imbalances or asymmetries amongst investors may still exist (e.g. a few insiders or investment experts possessing more information than others).
Overall, this can mean that markets that are expected to be highly efficient, such as the US treasury bond market or interbank money market, are likely to have limited opportunities for excess returns. Conversely, markets that have a larger base of unsophisticated investors or poor regulatory oversight, are more likely to provide opportunities to investors that are willing to put in the effort to gain informational advantages and conduct expert analysis.
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