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. 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 sem-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.

RELATED TERMS
  1. Semi-Strong Form Efficiency

    A class of EMH (Efficient Market Hypothesis) that implies all ...
  2. Strong Form Efficiency

    Strong form efficiency is a type of market efficiency that states ...
  3. Operational Efficiency

    Operational efficiency is primarily a metric that measures the ...
  4. Allocational Efficiency

    Allocational efficiency is a characteristic of an efficient market ...
  5. Passive Management

    Passive management refers to index- and exchange-traded funds ...
  6. Efficiency Ratio

    The efficiency ratio is used to analyze how well a company utilizes ...
Related Articles
  1. Insights

    The Efficient Market Hypothesis: Settling the Great Debate

    An understanding of neuroscience and the decision-making process provides a resolution to the decades-old debate between proponents and critics of the Efficient Market Hypothesis.
  2. Investing

    Modern Portfolio Theory Vs. Behavioral Finance

    Or: How financial markets would work in an ideal world vs. how they work in the real world.
  3. Investing

    The Evolution of ETFs

    Key 20th-century financial theories changed the way investors viewed markets and created the circumstances in which ETFs could emerge.
  4. Investing

    Seven Controversial Investing Theories

    Find out information about seven controversial investing theories that attempt to explain and influence the market as well as the actions of investors.
  5. Investing

    Strategies For Determining The Market's True Worth

    Learn the strengths and weaknesses of passive and active management when trying to uncover the overall market's worth.
  6. Trading

    Understanding Investor Behavior

    Discover how some human tendencies can play out in the market, posing the question: are we really rational?
  7. Investing

    Efficient Market Hypothesis

    An investment theory that states it is impossible to "beat the market".
  8. Investing

    The lowdown on index funds

    If you can't beat the market, why not join it? Read on to see what your options are.
  9. Financial Advisor

    High-yield Bond Investing: Information Is Key

    Access to and analysis of relevant information are the key to success in the high-yield bond market.
  10. Insights

    What Is International Trade?

    Everyone's talking about globalization, learn what is it and why some oppose it.
RELATED FAQS
  1. How Does an Efficient Market Affect Investors?

    The efficient market hypothesis refers to aggregated decisions of many market participants. Read Answer >>
  2. Why are efficiency ratios important to investors?

    Learn about efficiency ratios, such as the asset turnover ratio, and why these metrics are important to investors when analyzing ... Read Answer >>
  3. What is the difference between efficiency ratios and profitability ratios?

    Learn about efficiency and profitability ratios, what these ratios measure and the main difference between efficiency and ... Read Answer >>
Hot Definitions
  1. Inflation

    Inflation is the rate at which prices for goods and services is rising and the worth of currency is dropping.
  2. Discount Rate

    Discount rate is the interest rate charged to commercial banks and other depository institutions for loans received from ...
  3. Economies of Scale

    Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
  4. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
  5. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
  6. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
Trading Center