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What is Market Efficiency?

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  • Written By: Malcolm Tatum
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  • Last Modified Date: 14 September 2016
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Market efficiency is a term used to describe the degree that stock prices are representative of all data that is connected with a given marketplace. This means that the efficiency of the market is usually identified in degrees, with a strong market efficiency indicating that the prices are firmly and accurate reflections of what is happening in the market. In contrast, if a stock price does not appear to be related very strongly to prevailing market conditions, that is expressed as a weak market efficiency.

It is important to note that market efficiency does not necessarily mean that market conditions are the sole factors when considering the status of any given investment opportunity. Rather, the rate of efficiency exemplified by the relationship between current events in the market and the investment’s price are worthy of consideration along with other factors, if an investor is thinking of buying or selling that asset. There is some controversy in how much weight should be given to market efficiency when making these types of decisions.

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One concept that is related to market efficiency is known as the efficient market hypothesis, or EMH. Proponents of this approach state that it is impossible for an asset to outperform the market where it is traded, simply because all the relevant factors are already accounted for in the stock price. Detractors of this theory sometimes question if all these factors are indeed accounted for in the determination of the stock price, since the price may or may not adjust based on factors that investors may consider significant. While allowing that stock prices are normally determined based on information that is readily available, that information may or may not be interpreted properly, or may have an effect on investors that was overlooked or discounted by the markets themselves.

Since market efficiency is focused on the relationship of the price of assets in a given market, it is possible for an asset to have a strong market efficiency in one market, and be somewhat weaker in a different market. This is because perception of relevant information may vary somewhat, as well as how that specific bits of information are related to one another in the formulation of the market response. For this reason, there is no real way to say that a given asset has a specific market efficiency that is applicable in all times and all places. Investors must then look closely at what data each market is considering and determine for themselves if that data is complete and relevant, or if they believe more information or a different interpretation of that data is necessary in order to properly evaluate the potential of that investment.

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donasmrs
Post 3

@SarahGen-- It's something like that. If the market is not efficient, it just means that the information is not very reliable. Investors can always look at public information or ask people who work for that firm about the condition of the firm if they can't rely on the market for this information.

It's actually all very subjective. Like the article said, the same exact asset may have reliable prices in one market but not the other. It's really up to the investor decide what data they want to consider before making a decision. It's a tough call.

fBoyle
Post 2

@SarahGen-- The market efficiency hypothesis doesn't always make sense. So it's okay to be confused.

EMH assumes that investors are rational and that there is always enough information about different firms and their stocks. But in reality, this is not true. So I think it's a good idea to take the EMH with a pinch of salt.

That being said, the EMH does give investors an idea of what to look out for when they are buying or selling shares in a market. If market efficiency is weak, the EMH says that considering market prices is not helpful. Because prices don't accurately reflect how that firm or the market is doing.

SarahGen
Post 1

I don't think I understand market efficiency theory. If market efficiency is weak, does this mean that an investor should not rely on the stock market for decision making? But how else can an investor make decisions? It doesn't make sense to me.

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