How to Test Stock Market Efficiency

by Dennis Hartman

Market efficiency refers to a financial market's status as an open and unbiased place where commodities, such as shares of stock, are bought and sold. Because markets are complex, random deviation exists in the value of investments. However, investors' emotions and biases can affect prices as well. To test stock market efficiency, analysts employ a number of techniques aimed at predicting results and observing whether markets change as expected.

Identify Potential Inefficiencies

The first step in testing stock market efficiency is to identify potential sources of inefficiency. In an event study, which seeks to test market efficiency for a single stock, this means noting the precise time and nature of an event such as a major announcement, breaking news story or incident. In a portfolio study, which tests market efficiency for multiple stocks in a particular category, potential sources of inefficiency are known as variables. They include any pieces of information that investors may use to guide their buying and selling decisions.

Collect Data

Collecting data is central to any test of stock market efficiency. Each test has its own parameters based on what method it's testing and which source of inefficiency it examines. However, numerical data is always an essential element in the process. Analysts must determine the time frame for data collection. For example, in a test of market inefficiency following a new product announcement, analysts may choose to look at stock prices and trading volume in the two hour period following the announcement, or they may choose to examine stock prices for an entire fiscal quarter following the event. The scope of the analysis will likely yield different results.

Repeat Analysis

Because efficient markets are known to include randomness, the most effective tests of market efficiency examine multiple periods of time. Repeating a test numerous times for different incidents that are all of the same type helps to reveal whether results are random or there is a causal relationship between the event or variable and returns. For example, a new product announcement may cause a temporary dip in share prices followed by a slow rise in the day after an announcement in one case. However, this may be unique to a company that doesn't have a proven record of new products. Similar announcements may more often cause the opposite effect, indicating a different type of efficiency than the first test implied.

Adjustments and Results

To complete a test of stock market efficiency, analysts compile their data, calculate averages and make adjustments for additional factors. For example, some tests include steps for factoring in overall market performance to help isolate the effects of particular events or variables. Other tests account for market risk. In each case, the final results are ready for publication, along with the methods used as well as the conclusions of the test administrators.

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