Financial markets are relatively efficient, meaning that it is nearly impossible for an investor to consistently earn a return that exceeds the expected return that the investor should earn given the risk.
This statement effectively says that investors who trade in financial markets can expect to earn returns that are appropriate for the risk they assume. Financial markets are efficient because they are so competitive and information is fairly inexpensive. Thousands of investors continuously comb through the market looking for small bits of relevant information. When they find something useful, they trade on it and the information is rapidly incorporated into the prices of securities. Market efficiency results when no single investor can consistently earn returns that exceed the returns that are fair given the risk assumed. Any such returns that exceed those that are fair given the risk are called abnormal returns, excess returns, or alpha. On average, alphas are zero for all investors.
Of course whenever new information is discovered, someone will hear of it first and will unquestionably earn abnormal returns. Market efficiency does not rule out abnormal returns. It rules out only the fact that no single investor can earn them consistently. Of course, some very successful investors do appear to have earned abnormal returns. The existence of these investors could be because the theory is wrong or it could be because these investors are lucky. Luck has tremendous power to explain abnormal performance. Given a large enough set of competitors, a surprisingly large number will achieve remarkable results just through luck.
Financial market efficiency has important implications for companies when they think about issuing stock and bonds.
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Last updated: March 23, 2006