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Market efficiency

There is a lot of talk about the “efficient capital market”. Market efficiency describes the operating characteristics of the capital market. These are of two types:

• Operationally or internally efficient. In which an investor can do transactions as cheaply as possible. This would include brokerage, commissions, and other charges.
• Pricing or externally efficient. In which an investor can expect that stock prices at all times reflect all available information that is relevant to the evaluation of the stocks.

Risk and return

When the investor want to invest his money at a higher rate of return there is a higher factor of risk. As we would be exposing our money to the markets (equity, debt, etc.) and their associated risks. Further, the higher the risk taken, the higher is the expected return. In the bank the money is exposed to no risk, so the return is just at about the inflation rate. In contrast the risk in equity markets is the highest, and the expected returns would also be the highest. Before exposing ourselves to the markets, we can apply common sense and our learning to reduce this risk to acceptable levels.

There are 5 economic factors that affect equity returns, which can be classified under the 4 types of investment risk.