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.

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.

RELATED TERMS
  1. Market Value

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

    A field of finance that proposes psychology-based theories to ...
  3. Undervalued

    A financial security or other type of investment that is selling ...
  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 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. Fundamental Analysis

    What Causes Inflation in the United States

    Inflation is the main catalyst behind U.S monetary policy. But what causes this phenomenon of sustained rising prices? Read on to find out.
  5. Fundamental Analysis

    Is India the Next Emerging Markets Superstar?

    With a shift towards manufacturing and services, India could be the next emerging market superstar. Here, we provide a detailed breakdown of its GDP.
  6. Term

    Estimating with Subjective Probability

    Subjective probability is someone’s estimation that an event will occur.
  7. Investing Basics

    Understanding the Modigliani-Miller Theorem

    The Modigliani-Miller (M&M) theorem is used in financial and economic studies to analyze the value of a firm, such as a business or a corporation.
  8. Economics

    Explaining Kurtosis

    Kurtosis describes the distribution of data around an average.
  9. Personal Finance

    Simple Interest Loans: Do They Exist?

    Yes, they do. Here is what they are – and how to use them to your advantage.
  10. Options & Futures

    An Introduction To Value at Risk (VAR)

    Volatility is not the only way to measure risk. Learn about the "new science of risk management".
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. 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 >>
  4. 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 >>
  5. What is the utility function and how is it calculated?

    In economics, utility function is an important concept that measures preferences over a set of goods and services. Utility ... Read Full Answer >>
  6. How can I use a regression to see the correlation between prices and interest rates?

    In statistics, regression analysis is a widely used technique to uncover relationships among variables and determine whether ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Bubble Theory

    A school of thought that believes that the prices of assets can temporarily rise far above their true values and that these ...
  2. Stock Market Crash

    A rapid and often unanticipated drop in stock prices. A stock market crash can be the result of major catastrophic events, ...
  3. Financial Crisis

    A situation in which the value of financial institutions or assets drops rapidly. A financial crisis is often associated ...
  4. Election Period

    The period of time during which an investor who owns an extendable or retractable bond must indicate to the issuer whether ...
  5. Shanghai Stock Exchange

    The largest stock exchange in mainland China, the Shanghai Stock Exchange is a nonprofit organization run by the China Securities ...
  6. Dead Cat Bounce

    A temporary recovery from a prolonged decline or bear market, followed by the continuation of the downtrend. A dead cat bounce ...
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!