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What is Operational Efficiency?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 14 September 2016
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Sometimes referred to as an internally efficient market, operational efficiency is a situation within a market where investors who buy and sell in that market are able to do so at cost that is considered equitable to those investors. This type of allocational efficiency actually helps to move the market forward, since it helps to ensure that everyone participating within that market is satisfied with the costs they incur as a result of their decision to participate. It is important to note that a market may be considered efficient by some types of investors, but be considered highly inefficient by others.

An example of how operational efficiency in the marketplace functions is to consider a market in which the commission charged for trades was at a fixed rate, rather than being based on the number of shares involved with the trade. For investors who prefer to buy and sell in large blocks of shares, this fixed charge works very well, much more so than a charge based on the number of shares. For these investors, the operational efficiency of the market would be perceived as quite high. As a result, they would be prompted to execute more trades on a regular basis, stimulating the marketplace.

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At the same time, this fixed commission charge could inhibit investment activity among smaller investors. Since these investors would be more likely to engage in trades that involved odd lots, or lots of securities that are less than one hundred shares, or to purchase several even lots of a hundred shares, there is no cost savings on the commission to motivate them to engage in more frequent trading. Since the cost of trading is not as attractive as it would be if the norm was a floating commission based on the number of shares involved, smaller investors would likely consider the operational efficiency of the market to be somewhat low.

One of the effects of technology and the ability to execute trades online is that trading fees and commissions are much lower than they were in times past. This means smaller investors can sometimes execute trades where the costs are considered to be in line with the perceived benefits of making the trade. To a degree, this has helped to improve the operational efficiency of many investment markets, since the lower fees allow more investors of all sizes and types to actively participate without incurring costs they consider inequitable.

Shifts in regulations can sometimes have the effect of improving the operational efficiency of the marketplace. One example is the actions taken in 2000 by the Commodity Futures Trading Commission in the United States. A new resolution passed by the CFTC make it possible for money market funds to meet margin requirements, where once only cash was considered eligible. While this change went unnoticed by many investors, it did have the effect of increasing the operational efficiency of futures markets, since it reduced the costs of buying and selling in those markets.

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David09
Post 4

@NathanG - You’re correct–operational efficiency doesn’t just refer to stock markets or investments. It has to do with any attempt within the business climate to improve operations. For example sometimes governments experience budget shortfalls, at the state and at the local levels.

As a result, they bring in consultants to look at their operations and look at places where they can improve efficiencies and cut costs. Basically operational efficiency refers to any business process improvement, regardless of whether you’re talking about the public or private sector.

NathanG
Post 3

Does operational efficiency only refer to stock market investing? Could it also have some applications within the day-to-day business environment?

allenJo
Post 2

@hamje32 - It’s a double-edged sword, really. This is not meant to be a slam on anything that you said, really. It’s just a fact that with more investors going into the stock market using the do-it-yourself route instead of using a traditional brokerage firm, a lot of amateurs have entered the fray. As a result they added a lot of risk to the stock market since they don’t know how to handle its volatile up and downs.

I think a lot of the boom and bust cycles that we’ve had in the last two decades have been fueled by these amateur investors following the winds of the stock market. Again that’s not meant to be a criticism. It’s just a result of what has happened since investing has been made more accessible to the masses. But I certainly can’t disagree with the fact that online trading and fixed trades have improved the operational efficiency of the stock market.

hamje32
Post 1

The best thing that ever happened to me from an investing standpoint was online trading. I remember back in the day when I had to call my investment firm to execute trades. When I first started out of course I didn’t know what I was doing, so I would ask a lot of dumb questions. Even then, however, I thought it was more of a hassle to have to talk to someone on the telephone to make my investment decisions, so I made fewer investments. That’s just me, perhaps, but that’s how it worked.

With online trading—and smaller fees per trade—the situation changed dramatically. I made more investments online, more quickly, and was happier with the results. Of course

I am just one of millions of smaller investors who helped add this new dynamic to the market. I think it’s the best thing that has ever happened to stock market investing.

Eliminate the barriers to making people more profitable, make people more nimble, and you will have more economic activity. It makes perfect sense, whether you call it operating efficiency or whatever.

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