Inefficient Market

DEFINITION of 'Inefficient Market'

A theory which asserts that the market prices of common stocks and similar securities are not always accurately priced and tend to deviate from the true discounted value of their future cash flows. This theory opposes the efficient market hypothesis.

The phrase is also used to refer to a market which is not operating efficiently; for example, it could be argued that the low-volume stocks traded over the counter comprise an inefficient market compared to blue chip stocks.

BREAKING DOWN 'Inefficient Market'

The inefficient market hypothesis and its proponents contend that market forces sometimes drive asset prices above or below their true value. They find support for their argument from instances of market crashes or upward spikes, whose existence and magnitude are seemingly incompatible with an efficient market point of view.

Thus, in an inefficient market, some securities will be overpriced and others will be underpriced, which means some investors can make excess returns while others can lose more than warranted by their level of risk exposure. If the market were entirely efficient, these opportunities and threats would not exist for any reasonable length of time, since market prices would quickly move to match a security's true value as it changed. While financial markets appear reasonably efficient, events such as market-wide crashes and the dotcom bubble of the late '90s seem to reveal some sort of inefficiency within the markets.

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