Market Efficiency

What is Market Efficiency?

It’s a term used to describe how well current stock prices reflect all the facts that are available to analysts and investors.

An efficient market is also one in which any new information is passed to everyone seamlessly, leaving no room for stocks to be undervalued.

Table of Contents Table of Contents

1. What is Market Efficiency?
2. Key Takeaways
3. What is the Efficient Markets Hypothesis?
4. Market Efficiency Types
5. An Example of an Efficient Market
6. What is an Inefficient Market?
7. Making Money in Efficient Markets
8. The Bottom Line
9. FAQs
10. References

Show Full Guide

Table of Contents

1. What is Market Efficiency?
2. Key Takeaways
3. What is the Efficient Markets Hypothesis?
Show Full Guide
4. Market Efficiency Types
5. An Example of an Efficient Market
6. What is an Inefficient Market?
7. Making Money in Efficient Markets
8. The Bottom Line
9. FAQs
10. References

What is the Efficient Markets Hypothesis?

The concept of market efficiency can be explained by theories such as the Efficient Markets Hypothesis (EMH), which has been part of the investment landscape for decades.

Effectively, it declares that stock prices fully reflect all the available information and will adjust to new data before investors can trade on such insights.

EMH was developed in the 1960s by Eugene Fama, an American economist known for his work on portfolio theory and asset pricing. He received the Nobel Prize in Economic Sciences for his research into efficient markets, sharing the prize with Lars Peter Hansen and Robert J. Shiller.

Opposing Views to EMH

Not everyone accepts the concept of EMH. Sebastien Canderle, a private capital advisor, is among those who have questioned its economic interpretation.

He pointed out that the “notion of perfect information” ignored the fact that it can be manipulated, inaccurate, misleading, fraudulent, or difficult to understand. He wrote in a CFA Institute blog:

“Market prices can only reflect perfect information if all investors access the same data at the same time.”

He also pointed out that EMH offered a narrow definition of market efficiency that focused on data availability.

“This oversimplification fails to acknowledge that the market is more than just a reflection of data flows,” he added. “Other factors can create friction.”

Such factors include trade execution, price setting, and investor behavior.

Market Efficiency Types

Anyone looking at what is stock market efficiency needs to know there are actually three recognized types:

An Example of an Efficient Market

Let’s take a fictitious example of a quoted company that’s listed on the London Stock Exchange (LSE) for our insight into efficient markets.

If the LSE is an efficient market, then the share price of the company in question will perfectly reflect all the information on its business. Analysts and investors following the business will be able to accurately predict what is likely to happen to it so the chances of it springing a surprise will be slim.

The New York Stock Exchange and the Deutsche Boerse have been cited as standing out in terms of their integrity and high efficiency.

What is an Inefficient Market?

Conversely, it’s also worth looking at what constitutes an inefficient market. This is a market in which stock prices don’t successfully incorporate the available information.

It’s widely regarded that some emerging markets are inefficient because they are not so well-established or have fewer analysts following them.

Of course, there are pros and cons to inefficient markets. The positives are that there’s potentially greater scope to make money from information that hasn’t been embraced.

However, the downside is that these markets can often be riskier, suffering from increased volatility and the prospect of economic and political instability.

Making Money in Efficient Markets

The idea that markets are so efficient that all information about a company is likely to have already been priced into its valuation presents a conundrum for investors.

They may understandably question the logic of paying high fees for the expertise of active fund managers if it means they won’t be able to outperform the market.

Of course, the increasing acceptance of market efficiency has resulted in more people being drawn to passive investment styles.

What is Passive Investing?

Funds that track an index, as opposed to actively trying to outperform it, are regarded as having a passive investing style.

It’s less expensive than active management and one of the simplest ways to invest in the stock market, according to wealth manager Hargreaves Lansdown.

​​It stated: “In 2023, total global assets under management in passive funds surpassed active ones for the first time.”

As an aside, the first publicly available index fund was launched back in the mid-1970s thanks to the efforts of the late John C. Bogle, Vanguard’s pioneering founder.

Mr Bogle, whose work helped reduce costs within the mutual fund industry, famously declared: “Don’t look for the needle in the haystack. Just buy the haystack!”

The Bottom Line

The most accurate market efficiency definition refers to how well current stock prices reflect all the available information.

Basically, an efficient market means information about a company is likely to have already been priced into its valuation. It will have covered so many of the available bases for investors that outperforming it will be virtually impossible.

This concept has helped bolster enthusiasm for the so-called passive investing style, which seeks to track the performance of particular indices. The efficiency of a market will depend on how well different bits of information will be absorbed by analysts and investors.

However, not everyone buys into the concept. Critics of the Efficient Market Hypothesis claim that it can oversimplify situations and ignore influential factors.

FAQs