The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

CAPITAL MARKET PRICE EFFICIENCY

Later in this chapter, we explain the two major types of portfolio strategies: active versus passive. The decision as to which of the two approaches to pursue depends on the price efficiency of the market. A price efficient market is one where security prices at all times fully reflect all available information that is relevant to their valuation. When a market is price efficient, investment strategies pursued to outperform a broad-based stock market index will not consistently produce superior returns after adjusting for risk and transaction costs.

Numerous studies have examined the pricing efficiency of the stock market. While it is not our intent in this chapter to provide a comprehensive review of these studies, we can summarize the basic findings and implications for common stock portfolio management strategies.

Forms of Efficiency

There are three different forms of pricing efficiency: (1) weak form, (2) semistrong form, and (3) strong form. The distinctions among these forms rests in the relevant information that is believed to be taken into consideration in the price of the security at all times. Weak-form efficiency means that the price of the security reflects the past price and trading history of the security. Semistrong-form efficiency means that the price of the security fully reflects all public information (which, of course, includes but is not limited to, historical price and trading patterns). Strong-form efficiency exists ...