What Is Market Efficiency?

Market Efficiency
By JIM CHAPPELOW
Updated Aug 29, 2019
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. Market efficiency was developed in 1970 by economist Eugene
Fama, whose efficient market hypothesis (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.
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Market Efficiency Theory
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. Given this argument, momentum rules or technical analysis
techniques that some traders use to buy or sell a stock will not on average
be able to achieve above normal market returns. Excess returns might still
be possible using fundamental analysis under weak-form market efficiency.
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.

What Is Market Efficiency?

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What Is Market Efficiency?

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Market Efficiency

Market Efficiency Explained

The semi-strong form of market efficiency assumes that stocks adjust

Differing Beliefs of an Efficient Market

An Example of an Efficient Market

For example, the passing of the Sarbanes-Oxley Act of 2002, which

Other examples of efficiency arise when perceived market anomalies

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