What Is Market Efficiency?
Let me tell you directly: market efficiency defines the ability of markets to use information that provides the most opportunities to investors. In an efficient market, all pertinent information is already incorporated into prices. That means there are no undervalued or overvalued securities available, so there's no way for you to 'beat' the market.
The term 'market efficiency' comes from a 1970 paper by economist Eugene Fama, but Fama himself admits it's a bit misleading because no one has a clear definition of how to perfectly define or precisely measure it. Despite that, we use the term to refer to what Fama is best known for—the efficient market hypothesis (EMH).
The EMH states that you, as an investor, can't outperform the market, and market anomalies shouldn't exist because they'll immediately be arbitraged away. Fama later won the Nobel Prize for this work. If you agree with this theory, you'll likely buy index funds that track overall market performance and support passive portfolio management.
Key Takeaways
- Market efficiency refers to how well current prices reflect the actual value of the underlying assets.
- A truly efficient market eliminates the possibility of beating the market because any information available to any trader is already incorporated into the market price.
- As the quality and amount of information increases, the market becomes more efficient, reducing opportunities for arbitrage and above-market returns.
Understanding Market Efficiency
At its core, market efficiency is the ability of markets to incorporate information that provides the maximum amount of opportunities for you as a purchaser or seller of securities, without increasing transaction costs. Whether markets like the U.S. stock market are efficient, or to what degree, is a heated debate among academics and practitioners.
There are three degrees of market efficiency: the weak form, semi-strong form, and strong form. The weak form says that past price movements are not useful for predicting future prices. If all available, relevant information is incorporated into current prices, then any information from past prices is already in there. So, future price changes can only result from new information becoming available.
Based on this, investing strategies like momentum or technical-analysis-based rules shouldn't persistently achieve above-normal returns. Within this form, there might still be excess returns possible using fundamental analysis. This view has been taught in finance studies for decades, though it's not held as dogmatically now.
The semi-strong form assumes stocks adjust quickly to new public information, so you can't benefit over the market by trading on it. This means neither technical nor fundamental analysis would reliably give superior returns, because that information is already in current prices. Only private information unavailable to the market would help, and only if you have it before everyone else.
The strong form says market prices reflect all information, public and private, building on the others. Under this, no investor, even a corporate insider, could profit above average, even with new insider information.
Differing Beliefs of an Efficient Market
You and other investors and academics have a wide range of viewpoints on market efficiency, as seen in the strong, semi-strong, and weak versions of the EMH. Believers in the strong form agree with Fama and often go for passive index investing. Those with the weak version believe active trading can generate abnormal profits through arbitrage, while semi-strong believers are in the middle.
For example, on the other end from Fama are value investors, who believe stocks can become undervalued or priced below their worth. Successful value investors make money by buying when undervalued and selling when the price meets or exceeds intrinsic worth.
People who don't believe in an efficient market point to active traders existing. If there were no opportunities to beat the market, there'd be no incentive for active trading. Also, fees charged by active managers suggest the EMH isn't correct, as it implies low transaction costs in an efficient market.
An Example of an Efficient Market
While investors believe in both sides of the EMH, there's real-world proof that wider dissemination of financial information affects prices and makes markets more efficient.
For instance, the Sarbanes-Oxley Act of 2002 required greater financial transparency for public companies, and it led to a decline in equity market volatility after quarterly reports. Financial statements became more credible, making information reliable and building confidence in security prices. Fewer surprises meant smaller reactions to earnings reports. This shows the Act made the market more efficient by lowering transaction costs through better information.
Other examples include perceived market anomalies that disappear once widely known. For example, adding a stock to the S&P 500 used to boost its price just because of the addition, not fundamentals. But once reported, this anomaly largely disappeared. This means as information increases, markets become more efficient, and anomalies reduce.
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