What do you mean by market efficiency?

This reading has provided an overview of the theory and evidence regarding market efficiency and has discussed the different forms of market efficiency as well as the implications for fundamental analysis, technical analysis, and portfolio management. The general conclusion drawn from the efficient market hypothesis is that it is not possible to beat the market on a consistent basis by generating returns in excess of those expected for the level of risk of the investment.

• The efficiency of a market is affected by the number of market participants and depth of analyst coverage, information availability, and limits to trading.

• There are three forms of efficient markets, each based on what is considered to be the information used in determining asset prices. In the weak form, asset prices fully reflect all market data, which refers to all past price and trading volume information. In the semi-strong form, asset prices reflect all publicly known and available information. In the strong form, asset prices fully reflect all information, which includes both public and private information.

• Intrinsic value refers to the true value of an asset, whereas market value refers to the price at which an asset can be bought or sold. When markets are efficient, the two should be the same or very close. But when markets are not efficient, the two can diverge significantly.

• Most empirical evidence supports the idea that securities markets in developed countries are semi-strong-form efficient; however, empirical evidence does not support the strong form of the efficient market hypothesis.

• A number of anomalies have been documented that contradict the notion of market efficiency, including the size anomaly, the January anomaly, and the winners–losers anomalies. In most cases, however, contradictory evidence both supports and refutes the anomaly.

• Behavioral finance uses human psychology, such as behavioral biases, in an attempt to explain investment decisions. Whereas behavioral finance is helpful in understanding observed decisions, a market can still be considered efficient even if market participants exhibit seemingly irrational behaviors, such as herding.

The concept of market efficiency presupposes that if markets are efficient, all the available information is already reflected in prices. Therefore, nobody can beat the market, because there are no overvalued or undervalued securities.

The term was introduced by economist Eugene Fama in 1970 in his Efficient Market Hypothesis (EMH).

According to the EMH theory, an investor could not outperform the market, as prices completely reflect all available information about a particular asset. It means that no one has any advantage in forecasting a return on a stock price, for example, because no one has access to any information which is not yet available to everyone else.

In 2013, Eugene Fama was awarded the Nobel Prize in Economic Sciences.

Market efficiency meaning: non-predictability

Financial market information is not limited to financial news, market research and analyses. Everything, from economic and political to social events combined with investors’ perceptions of this information, is incorporated in stock prices.

In the efficient market, prices are random and not predictable. According to the Efficient Market Hypothesis, it makes a planned approach to investment impossible. Theory supporters prefer to invest in index funds that track the overall market performance and serve as examples of passive portfolio management.

Market efficiency at its core is the market’s ability to incorporate all the data that provides maximum opportunities to traders and investors. Whether the market is efficient is a topic of constant debate among practitioners and academics.

Market efficiency examples

There are 3 types of market efficiency: weak, semi-strong and strong. Together they constitute the elements of the Efficient Market Hypothesis (EMH).

• The weak form of market efficiency 

The theory of weak form of market efficiency states that past security price movement can’t be used for predicting future price action. It presupposes that all the relevant information is already reflected in current prices and all the future price changes will be affected only by new information that will become available.

According to this hypothesis, strategies based on technical analysis can’t persistently bring above normal market returns. It believes that fundamental analysis is more effective.

• Semi-strong form of market efficiency 

This theory assumes that stocks quickly absorb new information and investors can’t benefit above the market on this information. According to this form of market efficiency, neither fundamental nor technical analysis is efficient enough to bring superior returns, because even the fundamental data is already available to everyone and therefore, incorporated in the asset’s price. Only private information unavailable to market yet will be useful to get a trading advantage.

• The strong form of market efficiency 

This theory states that market prices incorporate and reflect all the information, both private and public. According to the strong form of market efficiency theory, stock prices already reflect all the information (private and public), which means that no one, even a corporate insider, will not be able to profit more than an average investor or trader.

Market efficiency refers to a market where prices represent all relevant financial information about an underlying asset or security. The more information that all market players will have, the more efficient the market is. It, thus, provides an equal opportunity for buyers and sellers to execute trades and make profits while minimizing transaction costs.

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The concept is connected with the market efficiency hypothesis, which is based on asset price changes due to the availability of relevant information. Since all traders have access to the same data, they cannot predict prices and outperform the market. Therefore, it plays a significant role in running the asset trade cycle in highly competitive financial markets.The term "financial market" refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more

• The market efficiency occurs when current market prices reflect all relevant financial information about an underlying asset or security.
• The more information available to all market participants, the more efficient the market becomes. Access to the same data makes investors unable to predict prices and outperform the market.
• An efficient market gives equal opportunity for buyers and sellers to profit in a liquid and highly competitive market while minimizing transaction costs, the likelihood of arbitrage, and above-market gains.
• The concept is linked to American economist Eugene Fama’s efficient market hypothesis in 1970 and is useful in commercial and financial scenarios.

How Market Efficiency Theory Works?

Market efficiency theory finds relevance in business and stock marketStock Market works on the basic principle of matching supply and demand through an auction process where investors are willing to pay a certain amount for an asset, and they are willing to sell off something they have at a specific price.read more situations. It is the most effective technique for investors who spend a large sum of money on financial instrumentsFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes.read more that provide risk-free profits. However, they cannot estimate asset price swings and out-profit others because prices are random and no assets or securities are overpriced or undervalued. The notion is closely associated with the efficient market hypothesis (EMH) that American economist Eugene Fama proposed in 1970.

Investors can profit in an efficient market because they have access to all essential information. Furthermore, they do not have to pay higher transaction costTransaction cost is the expense one incurs by engaging in economic exchange of any kind. Any activities associated with a market generate transactional costs. They represent the trade expenses that one needs to cover for aiding the trade of goods and services in a market.read more for trading financial instruments. As a result, it reduces arbitrageArbitrage in finance means simultaneous purchasing and selling a security in different markets or other exchanges to generate risk-free profit from the security's price difference. It involves exploiting market inefficiency to generate profits resulting in different prices to the point where no arbitrage opportunities are left.read more or above-market gains in a large, liquid, and highly competitive market.

Financial news, research, social, political, and economic factorsEconomic factors are external, environmental factors that influence business performance, such as interest rates, inflation, unemployment, and economic growth, among others.read more, rumors, etc., can influence the current value of an asset or security. In market efficiency, the amount of information accessible about security or asset is eventually reflected in its price. In reality, even if the market appears inefficient, portfolio managersA portfolio manager is a financial market expert who strategically designs investment portfolios.read more should consider it efficient since it keeps them active throughout the process.

The Sarbanes-Oxley ActThe Sarbanes-Oxley Act (Sox) of 2002 was enacted by the US Federal Law for increased corporate governance, strengthening the financial and capital markets at its core and boost the confidence of general users of financial reporting information and protect investors from scandals like that of Enron, WorldCom, and Tyco.read more of 2002 promoted this trading component and improved the reliability of the information. It gave investors more confidence in security pricing. The market became more efficient as a result.

Features

Market Efficiency Forms

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#1 – Weak

This form reveals all past information about asset or security pricing. However, past pricing details reflected in current prices are insufficient to assist investors in determining correct future trading prices. As a result, the weak form market efficiency will only result in asset undervaluation or overvaluation, affecting trade decisions.

#2 – Semi-Strong

It indicates that current prices consider all publicly available information about an asset or security. It also offers previous price details. As a result, it discourages investors from benefitting above the market by trading on the inside information.

#3 – Strong

It is the result of combining weak and semi-strong forms. This form shows market pricesMarket price refers to the current price prevailing in the market at which goods, services, or assets are purchased or sold. The price point at which the supply of a commodity matches its demand in the market becomes its market price.read more based on all accessible information (public, insider, and private). This insider knowledge, however, is neutral and available to all traders. As a result, despite having access to insider informationInsider Information is a piece of fact, information or an understanding (M&A, New Contracts, R&D breakthrough, new product launch etc.) which could impact the prices of a listed entity or publicly-traded organizations once disclosed in the public domain. Trading based on such information is considered to be illegal.read more, it ensures that all investors profit equally.

Examples of Market Efficiency

Let us consider the following market efficiency examples to understand the concept well:

Example #1

Assume that companies A and B are up for takeoverA takeover is a transaction where the bidder company acquires the target company with or without the management's mutual agreement. Typically, a larger company expresses an interest to acquire a smaller company. Takeovers are frequent events in the current competitive business world disguised as friendly mergers.read more. These companies’ stock values are lenient and stable for a few days, with only minor fluctuations. However, as soon as it was announced that a well-known corporation would be taking over both of them, their stock prices jumped.

In this instance, the takeover announcement adds new information to the current data for the companies’ stocks, resulting in a price change. As a result, the rise in stock prices indicates new positive information to the companies.

Example #2

Mary, a trader, is looking forward to purchasing stocks at a reduced price on one market and selling them at a higher price on another market. This type of trading, known as arbitrage, is the process of profiting from a pricing discrepancy. Unfortunately, even though an arbitrager can make a risk-free return in this situation, the market’s overall efficiency suffers. As a result, markets prohibit arbitrage and impose restrictions on acts that impede market efficiency.

Market Efficiency And Market Failure

Market efficiency also plays a crucial role in allocating resources to produce consumer-friendly goods. Resource allocation efficiency refers to a market where the value obtained for goods is equivalent to the predicted value.

Market failureMarket failure in economics is defined as a situation when a faulty allocation of resources in a market. It is triggered when there is an acute mismatch between supply and demand. As a result, prices do not match reality or when individual interests are not aligned with collective interests.read more, on the contrary, occurs when resource allocation efficiency is not attained. The market is likely to fail when the price mechanism fails to account for all costs and advantages essential for consumers when buying and using an item. In other words, when price and quality do not match, the market fails. To address market failure, the government enacts legislation, imposes taxes, gives subsidiesA subsidy in economics refers to direct or indirect financial assistance from the government to an individual, household, business, or institution to promote social and economic policies.read more, offers tradable permits, etc., depending on the nature of the market.

Frequently Asked Questions (FAQs)

What is market efficiency?

Market efficiency is when current market prices represent all essential financial information about an underlying asset or security. Financial news, research, economic, political, social variables, rumors, etc., can all affect the market value. An efficient market provides buyers and sellers equal access to precise and comprehensive asset-related data, allowing them to profit in a liquid and highly competitive market while limiting transaction costs, arbitrage opportunities, and above-market gains.

What are the three market efficiency forms?

The three forms of market efficiency are as follows:#1 – Weak (reveals all past information about asset or security pricing)#2 – Semi-Strong (shows all publicly available information about an asset or security, including past pricing details).

#3 – Strong (discloses market pricing based on all accessible public, insider, and private information)