Market Efficiency Explained: Differing Opinions and Examples (2024)

What Is Market Efficiency?

Market efficiency refers to the degree to which market prices reflect all available, relevant information. If markets are efficient, then all information is already incorporated into prices, and so there is no way to "beat" the market because there are no undervalued or overvalued securities available.

The term was taken from a paper written in 1970 by economist Eugene Fama, however Fama himself acknowledges that the term is a bit misleading because no one has a clear definition of how to perfectly define or precisely measure this thing called market efficiency. Despite such limitations, the term is used in referring to what Fama is best known for, the efficient market hypothesis (EMH).

The EMH states that an investor can't outperform the market, and that market anomalies should not exist because they will immediately be arbitraged away. Fama later won the Nobel Prize for his efforts. Investors who agree with this theory tend to buy index funds that track overall market performance and are proponents of passive portfolio management.

Key Takeaways

  • Market efficiency refers to how well current prices reflect all available, relevant information about 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.

At its core, market efficiency is the ability of markets to incorporate information that provides the maximum amount of opportunities to purchasers and sellers of securities to effect transactions without increasing transaction costs. Whether or not markets such as the U.S. stock market are efficient, or to what degree, is a heated topic of debate among academics and practitioners.

Market Efficiency Explained

There are three degrees of market efficiency. The weak form of market efficiency is that past price movements are not useful for predicting future prices. If all available, relevant information is incorporated into current prices, then any information relevant information that can be gleaned from past prices is already incorporated into current prices. Therefore future price changes can only be the result of new information becoming available.

Based on this form of the hypothesis, such investing strategies such as momentum or any technical-analysis based rules used for trading or investing decisions should not be expected to persistently achieve above normal market returns. Within this form of the hypothesis there remains the possibility that excess returns might be possible using fundamental analysis. This point of view has been widely taught in academic finance studies for decades, though this point of view is no long held so dogmatically.

The semi-strong form of market efficiency assumes that stocks adjust quickly to absorb new public information so that an investor cannot benefit over and above the market by trading on that new information. This implies that neither technical analysis nor fundamental analysis would be reliable strategies to achieve superior returns, because any information gained through fundamental analysis will already be available and thus already incorporated into current prices. Only private information unavailable to the market at large will be useful to gain an advantage in trading, and only to those who possess the information before the rest of the market does.

The strong form of market efficiency says that market prices reflect all information both public and private, building on and incorporating the weak form and the semi-strong form. Given the assumption that stock prices reflect all information (public as well as private), no investor, including a corporate insider, would be able to profit above the average investor even if he were privy to new insider information.

Differing Beliefs of an Efficient Market

Investors and academics have a wide range of viewpoints on the actual efficiency of the market, as reflected in the strong, semi-strong, and weak versions of the EMH. Believers in strong form efficiency agree with Fama and often consist of passive index investors. Practitioners of the weak version of the EMH believe active trading can generate abnormal profits through arbitrage, while semi-strong believers fall somewhere in the middle.

For example, at the other end of the spectrum from Fama and his followers are the value investors, who believe stocks can become undervalued, or priced below what they are worth. Successful value investors make their money by purchasing stocks when they are undervalued and selling them when their price rises to meet or exceed their intrinsic worth.

People who do not believe in an efficient market point to the fact that active traders exist. If there are no opportunities to earn profits that beat the market, then there should be no incentive to become an active trader. Further, the fees charged by active managers are seen as proof the EMH is not correct because it stipulates that an efficient market has low transaction costs.

An Example of an Efficient Market

While there are investors who believe in both sides of the EMH, there is real-world proof that wider dissemination of financial information affects securities prices and makes a market more efficient.

For example, the passing of the Sarbanes-Oxley Act of 2002, which required greater financial transparency for publicly traded companies, saw a decline in equity market volatility after a company released a quarterly report. It was found that financial statements were deemed to be more credible, thus making the information more reliable and generating more confidence in the stated price of a security. There are fewer surprises, so the reactions to earnings reports are smaller. This change in volatility pattern shows that the passing of the Sarbanes-Oxley Act and its information requirements made the market more efficient. This can be considered a confirmation of the EMH in that increasing the quality and reliability of financial statements is a way of lowering transaction costs.

Other examples of efficiency arise when perceived market anomalies become widely known and then subsequently disappear. For instance, it was once the case that when a stock was added to an index such as the S&P 500 for the first time, there would be a large boost to that share's price simply because it became part of the index and not because of any new change in the company's fundamentals. This index effect anomaly became widely reported and known, and has since largely disappeared as a result. This means that as information increases, markets become more efficient and anomalies are reduced.

Market Efficiency Explained: Differing Opinions and Examples (2024)


Market Efficiency Explained: Differing Opinions and Examples? ›

Market efficiency refers to how well current prices reflect all available, relevant information about 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.

What is an example of a market efficiency? ›

If the New York Stock Exchange is an efficient market, then Company ABC's share price perfectly reflects all information about the company. Therefore, all participants on the NYSE could predict that Company ABC would release the new product. As a result, the company's share price does not change.

What are the 3 keys to market efficiency? ›

Three common types of market efficiency are allocative, operational and informational. However, other kinds of market efficiency are also recognised.

What is market efficiency explain the forms of market efficiency? ›

Market efficiency refers to the ability possessed by markets to include information that offers maximum possible opportunities for traders to buy and sell securities without incurring additional transaction costs. The concept of market efficiency is closely linked to the efficient market hypothesis (EMH).

What is market efficiency for dummies? ›

What is an efficient market? Efficient market is one where the market price is an unbiased estimate of the true value of the investment.

What is an example of marketing efficiency? ›

As an example, say your last marketing campaign generated $10,000 in revenue from a $5,000 ad spend: You divide $10k by $5k (total revenue by total ad spend) That gives you an MER of 2 (10,000/5,000 = 2) We can express this total as a ratio, meaning MER in this example is 2.0.

What explains the efficiency of markets? ›

Market efficiency refers to how well current prices reflect all available, relevant information about 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.

What are the factors that affect market efficiency? ›

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.

What is an example of market inefficiency? ›

There are many real-world market inefficiency examples. Some of these are Microsoft (Windows), Apple Inc. (IOS), and utility firms among others. All these entities provide products with no direct substitutes, which gives them a great deal of control in the market.

How to improve market efficiency? ›

Make sure everyone is on the same page
  1. Align marketing goals with your company's goals. ...
  2. Get marketing and sales on the same page. ...
  3. Create specific briefings centered around a single, clear goal. ...
  4. Clearly highlight the project's benefits. ...
  5. Use one project management software. ...
  6. Use a shared method of communication.
Apr 30, 2019

Why is market efficiency important? ›

Market efficiency is crucial for investors, policymakers, regulators, and economists, as it provides insights into how markets function, how assets are priced, and how resources are allocated within the economy.

How is market efficiency determined? ›

Market efficiency is measured by arbitrage proximity. The level of efficiency is calibrated by extent of a distortion of probability required to neutralize the drift. Simulations of bilateral gamma models estimated from past returns deliver for each asset on each day an empirical acceptability index.

What is a simple but powerful measure of market efficiency? ›

AMIM is between zero and one if the market is inefficient, where closer to one means less efficient. When AMIM is smaller or equal to zero, the market is efficient. AMIM makes interpretation easy and facilitates a simple comparison of the efficiency levels for different assets over different time periods.

What are the best example of efficiency? ›

In general, we say something is efficient when it maximises outputs with given inputs. In other words, it's the ability to do something well and without waste. Often we try to measure efficiency levels, such as how energy efficient our light bulbs are or how efficient a business is at producing a product.

What is a real life example of efficiency in economics? ›

Economic efficiency is about making the most of scarce resources. For example, a car manufacturer is efficient if it produces cars at the lowest possible cost.

What is an example of a strong form of market efficiency? ›

Examples of Strong Form Efficiency in the Market

This transition is due to investors' reactions to the news, thereby integrating the new information into the stock's price. Strong Form Efficiency suggests that the current price after the announcement reflects all available information, both public and private.

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