Handbook of Market Risk

Chapter Two

The Efficient Markets Theory

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

—Warren Buffett

In this chapter we will examine a fundamental question about financial markets. This question has raised a lot of debates among practitioners and academics about its reality. The question is about market efficiency, along with the following questions: How do financial markets match providers with users and, more importantly, 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 highly volatile. The stock market is possibly the most volatile of them all. Some investors will win and some will lose. Is it just a matter of luck or skill? 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 is it so important at the end whether market prices for investments in fact offer fair returns? ...