The concept of efficient market is a special application of the \"no free lunch\
ID: 444858 • Letter: T
Question
The concept of efficient market is a special application of the "no free lunch" principle. In an efficient market, security prices fully reflect available information. No "excess" returns (i.e., no free lunch) can be earned based on the available information. Therefore "prices are right" implies "no free lunch". Does "no free lunch" imply "prices are right"? In other words, if participants in security markets observe no "excess" returns can be earned based on the observed security prices, does the observation of "no free lunch" imply "securities are correctly priced"?
Explanation / Answer
No. Markets can be wrong and the price is not always right.
The price is right principle says asset prices will, fully reflect available information, and thus provide accurate signals for resource allocation.
The no free lunch principle is that market prices are impossible to predict and so it is hard for any investor to beat the market after taking risk into account.
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