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What is 'Market Efficiency'

Market efficiency refers to the degree to which stock prices and other securities prices reflect all available, relevant information. Market efficiency was developed in 1970 by economist Eugene Fama, whose theory of efficient market hypothesis (EMH) stated it is not possible for an investor to outperform the market because all available information is already built into all stock prices. Investors who agree with this statement tend to buy index funds that track overall market performance and are proponents of passive portfolio management.

BREAKING DOWN 'Market Efficiency'

At its core, market efficiency measures the availability of market information that provides the maximum amount of opportunities to purchasers and sellers of securities to effect transactions without increasing transaction costs.

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 that the market is strong are those who agree with Fama, that is, passive investors. Practitioners of the weak version of the EMH believe active trading can generate abnormal profits, 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 actually 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 a 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 the passing of the Sarbanes-Oxley Act and its information requirements made the market more efficient.

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