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What is 'Market Efficiency'

Market efficiency refers to the degree to which market prices reflect all available, relevant information. If markets are efficient, than all information is already incorporated into prices, and so there is no way to "beat" the market because there are no under- or overvalued securities available. 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, and that market anomalies should not exist because they will immediately be arbitraged away. Fama later won the Nobel Prize for his efforts. Investors who agree with this theory tend to buy index funds that track overall market performance and are proponents of passive portfolio management.

At its core, market efficiency measures the ability of markets to incorporate information that provides the maximum amount of opportunities to purchasers and sellers of securities to effect transactions without increasing transaction costs. Whether or not markets such as the U.S. stock market are efficient, or to what degree, is a heated topic of debate among academics and practitioners.

BREAKING DOWN 'Market Efficiency'

There are three degrees of market efficiency:
The weak form of market efficiency assumes that past price movements have no effect on future rates. Given this assumption, momentum rules or technical analysis techniques that some traders use to buy or sell a stock are invalid. The semi-strong form of market efficiency assumes that stocks adjust quickly to absorb new public information, so that an investor cannot benefit over and above the market by trading on that new information. The strong form of market efficiency says that market prices reflect all information both public and private, building on and incorporating the weak form and the semi-strong form. Given the assumption that stock prices reflect all information (public as well as private), no investor, including a corporate insider, would be able to profit above the average investor even if he were privy to new insider information. Several statistical and applied tests have been developed to test the degree of efficiency in a market.

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, and often consist of passive index investors. Practitioners of the weak version of the EMH believe active trading can generate abnormal profits through arbitrage, 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 that the passing of the Sarbanes-Oxley Act and its information requirements made the market more efficient.

Other examples of efficiency arise when perceived market anomalies become widely known and then subsequently disappear. For instance, it was once the case that when a stock was added to an index such as the S&P 500 for the first time, there would be a large boost to that share's price simply because it became part of the index and not because of any new change in the company's fundamentals. This index effect anomaly became widely reported and known, and has since largely disappeared as a result. This means that as information increases, markets become more efficient and anomalies are reduced.

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