Market Efficiency Levels | CTFA Exam Preparation

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Market efficiency is the degree to which market prices reflect all available, relevant information. There are three levels of market efficiency: weak, semi-strong, and strong.

The weak-form efficiency states that all past market information, including price and volume data, is already reflected in stock prices. Therefore, technical analysis or trend-following techniques are not useful in generating superior returns.

The semi-strong form of market efficiency states that not only is all past market information already reflected in stock prices, but also all publicly available information, including financial statements, news reports, and analysts' forecasts, are already incorporated in the stock price. Therefore, fundamental analysis is not useful in generating superior returns.

The strong form of market efficiency states that all information, both public and private, is already reflected in the stock price. Thus, no investor can earn abnormal returns by using any type of analysis.

The Low PE effect, the Neglecting firm effect, and the Small firm effect are all examples of anomalies in financial markets that suggest that the markets may not be fully efficient.

The Low PE effect suggests that stocks with low price-to-earnings (PE) ratios tend to earn higher returns than stocks with high PE ratios. This contradicts the efficient market hypothesis, which would predict that low PE stocks should have the same expected returns as high PE stocks.

The Neglecting firm effect suggests that small firms that are neglected by analysts and the media tend to earn higher returns than larger, well-known firms. Again, this contradicts the efficient market hypothesis, which would predict that well-known firms should have the same expected returns as neglected firms.

The Small firm effect suggests that small firms tend to earn higher returns than large firms, again contradicting the efficient market hypothesis.

On the other hand, the Common size effect is not related to market efficiency. It refers to the tendency of companies with high total assets to have lower profit margins than those with low total assets, due to economies of scale.