What is an efficient market and how does it affect individual investors?

By Investopedia Staff AAA
A:

When people talk about market efficiency they are referring to the degree to which the aggregate decisions of all the market's participants accurately reflect the value of public companies and their common shares at any moment in time. This requires determining a company's intrinsic value and constantly updating those valuations as new information becomes known. The faster and more accurate the market is able to price securities, the more efficient it is said to be.

This principle is called the efficient market hypothesis, which asserts that the market is able to correctly price securities in a timely manner based on the latest information available and therefore there are no undervalued stocks to be had since every stock is always trading at a price equal to their intrinsic value. However, the theory has its detractors who believe the market overreacts to economic changes, resulting in stocks becoming overpriced or underpriced, and they have their own historical data to back it up.

For example, consider the boom (and subsequent bursting) of the dotcom bubble in the late nineties and early noughties. Countless technology companies (many of which had not even turned a profit) were driven up to unreasonable price levels by an overly bullish market. It was a year or two before the bubble burst, or the market adjusted itself, which can be seen as evidence that the market is not entirely efficient, at least not all of the time. In fact, it is not uncommon for a given stock to experience an upward spike in a short period, only to fall back down again (sometimes even within the same trading day). Surely, these types of price movements do not entirely support the efficient market hypothesis.

It is reasonable to conclude that the market is considerably efficient most of the time. However, history has proved that the market can overreact to new information (both positively and negatively). As an individual investor, the best thing you can do to ensure you pay an accurate price for your shares is to research a company before purchasing their stock, and analyze whether or not the market appears to be reasonable in its pricing.

(For further reading, see What Is Market Efficiency?, Working Through The Efficient Market Hypothesis and Understanding Investor Behavior.)

RELATED FAQS

  1. What exactly is being done when shares are bought and sold?

    Most stocks are traded on physical or virtual exchanges. The New York Stock Exchange (NYSE), for example, is a physical exchange ...
  2. What is the difference between arbitrage and speculation?

    Arbitrage and speculation are very different strategies. Arbitrage involves the simultaneous buying and selling of an asset ...
  3. How does FINRA differ from the SEC?

    With all the financial organizations out there, knowing what they all do can be as complicated as knowing where to invest. ...
  4. What is the difference between the Dow and the Nasdaq?

    Because of the way people throw around the words "Dow" and "Nasdaq," both terms have become synonymous with "the market," ...
RELATED TERMS
  1. Current Liquidity

    The total amount of cash and unaffiliated holdings compared to ...
  2. Market Value

    The price an asset would fetch in the marketplace. Market value ...
  3. Developed To Net Premiums Earned

    The ratio of developed premiums to net premiums earned over a ...
  4. Return On Policyholder Surplus

    The ratio of an insurance company’s net income to its policyholder ...
  5. Absolute Percentage Growth

    An increase in the value of an asset or account expressed in ...
  6. Capital Loss Coverage Ratio

    The difference between an asset’s book value and the amount received ...
Related Articles
  1. How A Limited Government Affects A Country's ...
    Economics

    How A Limited Government Affects A Country's ...

  2. How Does Goodwill Affect Financial Statements?
    Investing Basics

    How Does Goodwill Affect Financial Statements?

  3. Using Normal Distribution Formula To ...
    Investing Basics

    Using Normal Distribution Formula To ...

  4. An Introduction to Government Loans
    Economics

    An Introduction to Government Loans

  5. The Government And Risk: A Love-Hate ...
    Insurance

    The Government And Risk: A Love-Hate ...

Trading Center