Inefficient Market

AAA

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.

INVESTOPEDIA EXPLAINS '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.

RELATED TERMS
  1. Market Value

    The price an asset would fetch in the marketplace. Market value ...
  2. Undervalued

    A financial security or other type of investment that is selling ...
  3. Behavioral Finance

    A field of finance that proposes psychology-based theories to ...
  4. Overvalued

    A stock with a current price that is not justified by its earnings ...
  5. Efficient Market Hypothesis - EMH

    An investment theory that states it is impossible to "beat the ...
  6. Random Walk Theory

    The theory that stock price changes have the same distribution ...
RELATED FAQS
  1. What can cause an asset to trade below its market value?

    An asset may trade below its market value due to a lack of demand for the asset in the marketplace, a perception or belief ... Read Full Answer >>
  2. Do speculators have a destabilizing effect on the financial system?

    A speculator is anyone who trades derivatives, commodities, bonds, equities or currencies with higher-than-average risk in ... Read Full Answer >>
  3. What is an efficient market and how does it affect individual investors?

    When people talk about market efficiency they are referring to the degree to which the aggregate decisions of all the market's ... Read Full Answer >>
  4. Do noise traders have any long-term effect on stock prices?

    There are two theories that are used to describe how securities are priced in the stock market: the efficient market hypothesis ... Read Full Answer >>
  5. How do I calculate a modified duration using Matlab?

    The modified duration gauges the sensitivity of the fixed income securities to changes in interest rates. To calculate the ... Read Full Answer >>
  6. How do I calculate the rule of 72 using Matlab?

    In finance, the rule of 72 is a useful shortcut to assess how long it takes an investment to double given its annual growth ... Read Full Answer >>
Related Articles
  1. Active Trading Fundamentals

    Understanding Investor Behavior

    Discover how some strange human tendencies can play out in the market, posing the question: are we really rational?
  2. Fundamental Analysis

    Find The Right Fit With Probability Distributions

    Discover a few of the most popular probability distributions and how to calculate them.
  3. Active Trading Fundamentals

    Efficient Market Hypothesis: Is The Stock Market Efficient?

    Deciding whether it's possible to attain above-average returns requires an understanding of EMH.
  4. Economics

    Understanding Limited Liability

    Limited liability is a legal concept that protects equity owners from personal losses due to their ownership interest in the company.
  5. Fundamental Analysis

    Explaining the Empirical Rule

    The empirical rule provides a quick estimate of the spread of data in a normal statistical distribution.
  6. Economics

    Explaining Demographics

    Demographics is the study and categorization of people based on factors such as income level, education, gender, race, age, and employment.
  7. Fundamental Analysis

    Calculating Degree of Financial Leverage

    Degree of financial leverage (DFL) is a metric that measures the sensitivity of a company’s operating income due to changes in its capital structure.
  8. Economics

    What Does Capital Intensive Mean?

    Capital intensive refers to a business or industry that requires a substantial amount of money or financial resources to engage in its specific business.
  9. Investing Basics

    What Does Nominal Mean?

    Nominal refers to an unadjusted value or change in value.
  10. Fundamental Analysis

    The Importance Of LIBOR In Financial Markets

    What is LIBOR and why are its interest rates so important to the financial markets?

You May Also Like

Hot Definitions
  1. Bund

    A bond issued by Germany's federal government, or the German word for "bond." Bunds are the German equivalent of U.S. Treasury ...
  2. European Central Bank - ECB

    The central bank responsible for the monetary system of the European Union (EU) and the euro currency. The bank was formed ...
  3. Quantitative Easing

    An unconventional monetary policy in which a central bank purchases private sector financial assets in order to lower interest ...
  4. Current Account Deficit

    A measurement of a country’s trade in which the value of goods and services it imports exceeds the value of goods and services ...
  5. International Monetary Fund - IMF

    An international organization created for the purpose of: 1. Promoting global monetary and exchange stability. 2. Facilitating ...
  6. Risk-Return Tradeoff

    The principle that potential return rises with an increase in risk. Low levels of uncertainty (low-risk) are associated with ...
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!