Information is the ‘key’ to making better investment decisions. Access to information can almost always ensure that your investments turn out to be in your favor. Imagine a world where everyone has equal access to information — a marketplace where all of us have a level playing field. It enables people to make rational investment decisions. Thus, the odds of making a profit are the same for everyone. We call this world the ‘efficient market.’
The idea of market efficiency is a fascinating topic in finance and economics. One can thank this concept for popularizing passive investing.
In this article, we will find out whether such a fair world exists. Join us as we explore the features of an efficient market and its implications.
What Is Market Efficiency and Its Origin?
Market efficiency is a metric used to measure the extent to which asset prices incorporate all relevant information. If the market is 100% efficient, the prices of financial assets already reflect everything people know about them. These assets include stocks, bonds, crypto, real estate, etc.
So, it’s hard to beat the average market returns as the asset prices are equal to or close to their intrinsic value. The idea of an efficient market came from a paper written by economist Eugene Fama in 1970. It’s called the ‘Efficient Market Hypothesis (EMH).’ He even won a Nobel Prize for it. People often use the EMH to build their investment portfolio.
How Does Market Efficiency Function?
According to EMH, it is impossible for an investor to consistently outperform the market by using any analysis. It suggests that market participants will quickly eliminate any inefficiencies in the asset price as the information is readily available. Thus, it’s not possible to always make an additional profit in the market.
People who believe in this idea tend to invest in the broader market, like index funds. They don’t try to pick individual stocks or cryptos as it’s futile. This approach aligns with the EMH, as it acknowledges that it is difficult to beat the market consistently and instead aims to match its returns.
But, whether the markets are efficient and to what extent is still a topic of debate among experts and professionals. For instance, many prominent investors have continually demonstrated their ability to beat the market with their astute investment strategies. This includes the likes of Benjamin Graham, Peter Lynch, Carl Icahn, Warren Buffet, and Rakesh Jhunjhunwala. This showcases some level of inefficiency in the market that one can use to earn above-average returns.
Various Forms of Market Efficiency
There are three forms of market efficiency — weak, semi-strong and strong.
It is difficult to measure the efficiency of a market in practice. Thus, the forms discussed here are often used as a benchmark to evaluate the characteristics of a market.
1. Weak form
Weak form states that past prices can’t tell you what will happen in the future. It is because all current public information is already reflected in the existing price. This essentially means technical tools that rely on past data points, like volume or price indicators, won’t work.
But you might be able to make a profit through fundamental analysis by using existing information about a company’s financial health, like its earnings or debt.
2. Semi-strong form
In the semi-strong version, technical and fundamental analysis will not give an edge over other investors. This is because all publicly available information (both past and present data points) is already incorporated into the current asset prices.
The semi-strong version indicates that current prices of securities include all publicly available information. As per this version, securities adjust quickly to new information, so traders cannot make a profit by using it.
But, those who have access to private or insider information can outperform the market.
3. Strong form
The strong form states that all public and private information is reflected in market prices. Public information includes past prices, trading volume, and so on. Private or insider information refers to privileged information that is not available to the general public and can affect a company’s stock price. In the context of the stock market, insider information can include upcoming product launches, mergers and acquisitions, and other information that has not yet been made public.
In this form, they would not be able to earn higher returns than the average market returns in the long run. Thus, the only way to make returns is by buying and holding an index fund.
Features of an Efficient Market
An efficient market is one with the following attributes.
- The market is large in size and liquid.
- Information is readily available to everyone, so no one has an unfair advantage. Also, new information helps the market become even more efficient.
- Prices reflect all the information, both current and historical data points. Everyone pays a fair price for the asset.
- No one can consistently predict the future of an asset because everyone has the same information.
- It’s almost impossible to beat the broader market returns. Thus, investing in an index fund is the only effective strategy for getting returns.
One example of an efficient market is the foreign exchange or forex market. It is the world’s largest and most liquid financial market.
Forex prices constantly change based on economic conditions, political developments, and other factors. These changes are reflected in the prices almost immediately. Also, the forex market is open 24 hours a day, five days a week, allowing traders to react to news and events as they happen, contributing to its efficiency.
Additionally, the forex market is highly liquid with a high trading volume, which ensures that trades are executed at the current market price. This leads to low transaction fees due to minimal bid-ask spread.
Differing Views on the Market’s Efficiency
The concept of market efficiency is a matter of debate among investors and academics.
Passive index investors align with the views of Eugene Fama and believe in strong form efficiency. They believe they can’t outperform the market in the long run. Additionally, practitioners of the weak version believe active investing can generate uncommon profits through fundamental analysis. Finally, the semi-strong believers fall somewhere in the middle.
Critics of this concept point out that the presence of active traders and investors suggests that there are opportunities for profits that exceed the market average, which contradicts the EMH. Also, the high fees charged by active managers indicate that the market is inefficient. When transaction fees are high, it can be more difficult for some investors, particularly smaller ones, to enter the market and compete with more prominent investors. This can lead to a situation where some investors are able to make more returns at the expense of others.
Additionally, high transaction fees can discourage trading, which can reduce the liquidity of a market and make it more difficult for investors to buy and sell securities. This contradicts the EMH as it suggests that efficient markets have low transaction costs.
Like any idea, the concept of an efficient market has its detractors and supporters.
Critics point out successful portfolio managers and investors as proof that the market is inefficient.
On the other hand, people who support this idea say that in a market with many players — Some will do better than others due to chance or luck, not because they are skilled at it.
Additionally, behavioral finance studies have shown that there are biases in asset prices, such as confirmation bias, overconfidence, and loss aversion. These biases can affect the market and make it less efficient.
To summarize, one should measure market efficiency in a spectrum rather than viewing it in a binary form.
1. How are market efficiency and market failure related?
Market efficiency refers to the idea that markets can correctly incorporate all available information and reach an equilibrium price. Market failure refers to scenarios where markets do not function efficiently and fail to reach an equilibrium price.
A market is efficient when prices reflect all relevant information and transactions occur at the correct price. However, there are situations where markets may not function efficiently and fail to reach their true value. Factors such as information asymmetry, externalities, and monopoly power can cause market failure.
2. What is the importance of the efficient market hypothesis?
The efficient market hypothesis (EMH) provides a framework for understanding how financial markets work.
The EMH has several implications for the market participants.
- Investment strategy: The EMH suggests it is difficult to consistently beat the market by picking individual securities. This has led to the development of passive investment strategies, such as index funds, which track the overall market.
- Risk and return: The EMH suggests that investors are compensated for taking risks by earning higher returns. Thus, investors must be willing to accept some level of risk to achieve higher returns.
- Transparency and regulation: The EMH suggests that markets function best when information is widely available and reliable.
3. What causes market inefficiency?
Market inefficiency refers to situations where prices do not reflect all available information and transactions do not occur at the correct price.
Several factors can cause market inefficiency.
- Information asymmetry
- Behavioral biases
- Market manipulation
- Government intervention
- Market frictions, etc