Market efficiency refers to the ability possessed by markets to include information that offers maximum possible opportunities for traders to buy and sell securities without incurring additional transaction costs. The concept of market efficiency is closely linked to the efficient market hypothesis (EMH).
Efficient Market Definition
An efficient market is a place where the market prices of financial instruments like stocks reflect all information that is available. It also adjusts instantaneously to any new information that may be disclosed. If this theory holds true, then it is impossible for traders to consistently outperform a market, as the price movements of the assets cannot be predicted correctly.
Features of an Efficient Market
The features of an efficient market are as follows –
- In a truly efficient market, the prices of securities reflect all relevant information about the asset, including historical data such as price, volume and more.
- An efficient market allows investors an opportunity to outperform.
- With the disclosure of new information, the efficiency of the market increases, diminishing the opportunities for excess returns and arbitrage.
- It’s important to note that market efficiency does not suggest that the price of security is its true intrinsic value. It only states that market participants cannot predict the future price of an asset on a consistent basis.
Types of Market Efficiency
According to the efficient market theory formulated by American economist Eugene Fama, there are three forms of efficiency. They are –
This form of market efficiency theory suggests that current market prices of securities reflect their previous or historical prices. Thus, it means that market participants who are buying and selling securities by analysing their historical data should earn normal returns. Hence, any new price changes in future can only take place if new information becomes publicly available.
According to this theory, popular investing strategies like technical analysis or momentum trading will not be able to beat the market on a consistent basis. But, it proposes that there is room for earning excess returns by using fundamental analysis.
In a semi-strong variation of an efficient market, the current prices of securities represent all information that is publicly available. It includes historical information like price, volume and more. This form of theory assumes that securities make quick adjustments in response to any newly available information. Thus, traders won’t be able to outperform the market by trading on such information.
It dismisses both technical and fundamental analysis since any information gathered by using these techniques will already be available to other investors. Only private information that is unavailable in the market would be useful for an investor to have the edge over others.
This form of market efficiency theory states that market prices of securities reflect public and private information both. Consequently, investors will not be able to beat the market by trading on any private information since all such information will already be factored into the market prices of the securities.
How can a Market Become Efficient?
Investors play a vital role in making a market efficient. But, to make it happen, they must have a notion that the market is inefficient in the first place and cannot be outperformed. Amusingly, investment strategies that are adopted by various investors to exploit market inefficiencies play an essential part in making the market efficient.
Moreover, there are some requirements that must be fulfilled so that the market becomes efficient. They are discussed below:
- The market has to be large in size and liquid.
- All market-related information must be made available to every investor at the same time.
- It must be ensured at all times that the transaction costs are lower than the investment strategy’s estimated returns.
- Investors must have sufficient funds to exploit the inefficiencies in the market till the time they exist.
Stock Market Efficiency
What participants think of efficient markets depends solely on their individual views as to whether they can outperform it. This argument orbits around both active and passive trading approaches.
Investors who are fond of a passive approach are usually inclined to subscribe to the efficient market theory. Thus, they choose to invest in exchange-traded funds or index funds. These two offer similar returns when compared to the overall stock market. Passive investors steer clear from taking huge risks and do not have any intention to outperform.
These investors will rarely invest through a fund manager irrespective of the expertise. They believe that those fund managers cannot outperform the market. This doesn’t imply those fund managers cannot beat the market. Recent studies show that many investors have succeeded in outperforming the market on a consistent basis.
Now that you have a clear idea regarding market efficiency, it’s for you to decide which trading approach is best suited for you.