What is an Inefficient Market

An inefficient market, according to efficient market theory, is one in which an asset's market prices do not always accurately reflect its true value. These often lead to deadweight losses. Efficient market theory, or more accurately, the efficient market hypothesis (EMH) holds that in an efficient market, asset prices accurately reflect the asset's true value. In an efficient stock market, for example, all publicly available information about the stock is fully reflected in its price. In an inefficient market, in contrast, all the publicly available information is not reflected in the price, suggesting that bargains are available.

The EMH takes three forms: weak, semi-strong, and strong. The weak form asserts that an efficient market reflects all historical publicly available information about the stock, including past returns. The semi-strong form asserts that an efficient market reflects historical as well as current publicly available information. And, according to the strong form, an efficient market reflects all current and historical publicly available information as well as non-public information.

BREAKING DOWN Inefficient Market

Proponents of the EMH believe that the market's high degree of efficiency makes outperforming the market difficult. Most investors would, therefore, be well-advised to invest in passively managed vehicles such as index funds and exchange-traded funds (ETF), which don't attempt to beat the market. EMH skeptics, on the other hand, believe that savvy investors can outperform the market, and therefore actively managed strategies are the best option.

Regarding passively managed versus actively-managed vehicles, both sides may be right. One strategy may be best for one part of the market and the other may be best for another. For example, large-cap stocks are widely held and closely followed. New information about these stocks is immediately reflected in the price. News of a product recall by General Motors, for example, is likely to immediately result in a drop in GM's stock price. In other parts of the market, however, particularly small caps, some companies may not be as widely held and closely followed. News, whether good or bad, may not hit the stock price for hours, days, or longer. This inefficiency makes it more likely that an investor will be able to purchase a small-cap stock at a bargain price before the rest of the market become aware of and digests the new information.

Thus, in an inefficient market, some investors can make excess returns while others can lose more than expected, given 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 many 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 market inefficiency.