What it means
Imagine that thousands of smart, well-informed investors are competing to find undervalued shares. If a company announces better-than-expected profit, many of them will buy straight away, pushing the price up within seconds.
By the time an ordinary investor reads the news, the price has already changed, so there is no easy gain. The economist Eugene Fama formalised the idea and described three levels.
In weak form efficiency, prices reflect all past price information, so studying charts does not help. In semi-strong form, prices reflect all public information, such as financial statements and news, and in strong form they reflect even private information.
If markets are efficient, the best approach for most investors is to hold a broadly diversified portfolio at a low cost, because paying fees for active stock picking will not usually produce better returns. This is the logic behind index funds.
The prices of shares then follow a random path, moving only when new information arrives. Not everyone agrees that markets are fully efficient.
Critics point to bubbles, crashes and investor behaviour that seems driven by emotion, and some managers do appear to beat the market over long periods. The more common view today is that markets are mostly efficient, but not perfectly, with more efficiency in large, heavily traded markets than in small or obscure ones.
For a business, the idea matters in several ways. It suggests that a company's share price is a useful signal of its value, that trying to time the market with share issues or buybacks is unlikely to be consistently successful, and that managers should focus on creating real value instead.
It also underpins many valuation methods in corporate finance. Anomalies are the most studied exceptions.
Researchers have found patterns such as small companies outperforming or prices drifting after earnings news, but these effects often shrink once they become well known and traders act on them.
In practice
Real-world examples.
Example
A drug company announces that its new treatment has passed a key trial. Within minutes the share price jumps 20%, and later buyers get no unusual profit. This is consistent with an efficient market, since the news was absorbed almost immediately.
Example
A retail investor spends many hours studying price charts to predict the next move of a share. Over several years her results are no better than those of a simple index fund, after costs. She switches to a low-cost fund and saves time. She uses the saved hours to focus on her career.
Example
A company's finance director considers delaying a share issue because she thinks the price is too low. The board notes that the market price reflects all known information, so it is hard to be sure. They decide to issue shares when funds are needed. They raise the money on schedule and avoid distraction.
Formula
Calculation
Abnormal return = Actual return - Expected return
Suppose a share has an expected return of 1% on a normal day, based on the market's movement and the share's risk. On the day the company announces unexpectedly good profit, the share rises by 6%.
The abnormal return is 6% - 1% = 5%. In an efficient market, this 5% appears on the day of the announcement, and investors who buy afterwards earn only the normal expected return. A $100,000 holding gains an extra $5,000 for those who held it before the news, but no extra gain for those who bought afterwards.Case study
Seen in the real world.
Quarry Hill Partners is a fictional fund manager that charged 1.5% a year for actively picking shares. Over ten years, its main fund returned 7% a year before fees, while the market index it measured against returned 7.5% a year.
After the 1.5% fee, investors received 5.5% a year, which was 2.0 percentage points less than the index. On a $200,000 investment held for ten years, the index would grow to about $412,000 and the fund to about $342,000.
In this illustrative case, a group of investors moved their money to a low-cost index fund. The fund manager argued that markets were not perfectly efficient and that skill would pay in the long run, but the investors preferred the lower costs and more certain results. The fund's assets fell by almost a third over the next two years.
Watch out
Common mistakes.
- Believing efficient markets mean prices are always correct, when it only means prices reflect available information, which can still be wrong or incomplete.
- Assuming that no investor can ever beat the market, when some may do so by luck or skill, but it is hard to do consistently.
- Confusing efficient markets with markets that never fall, when prices can drop sharply if bad news arrives.
Questions
People also ask.
What are the three forms of market efficiency?
They are weak, semi-strong and strong form, depending on how much information is reflected in prices.
Why do index funds relate to this idea?
If markets are efficient, low-cost funds that match the market are a sensible choice for most investors.
Are all markets equally efficient?
No. Large and heavily traded markets are generally more efficient than small, thinly traded ones.
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