Role of market efficiency:
Market efficiency signifies how ‘quickly and accurately' does relevant information have its effect on the asset prices. Depending upon the degree of efficiency of a market or a sector thereof, the return earned by an investor will vary from the normal return (return appropriate to risk level).
Assumptions for Informationally Efficient Market
According to Efficient Market Hypothesis (EMH), successive absolute short run price changes are independent. The hypothesis is based on the assumption that the market comprises rational investors. The term ‘rational' means that investors will select assets based on their risk-return profile. If the behavior of the market participants, as revealed by various empirical studies, towards various kinds of value relevant information is compared with this term, we will see that the very assumption of EMH comes under cloud. It must be noted that empirical results existed well before the attempts were made to formulate a theory for explaining those results; therefore, issues like competitive market, quicker adjustment to information, informed market participants, easy access to markets, are not a part of EMH, but rather explanations of empirical results.
The very phenomenon of market equilibrium brings to the fore the point that mispricing is the basic feature of any market. Only the duration, speed and frequency with which this mispricing disappears as a result of the action of various market participants is something worth examining. Technical analysis, as an approach, has been fairly useful in detecting trends and reversals of market movement. A majority of the mutual funds which entered when the market was ascending great heights are performing poorly even after several years, thus, emphasizing the importance of time as a factor. The mere fact that technical analysis will not fetch abnormal returns consistently does not render it redundant. Technical analysis only gives an idea about the likely range of price movements and reversals, and there is no serious attempt on its part to predict the future price. Moreover, technical analysis is commonly used as a supplement to fundamental analysis. Tests conducted to examine trading strategies based on technical analysis do not support its exclusive use. It is argued that the strategies are tested separately, instead of testing them together and then arriving at a weighted result.