What it means
Imagine that a company announces better profits than anyone expected. In an efficient market, the share price jumps almost immediately to its new fair level, and an investor who reads the news a few minutes later has missed the opportunity.
The more quickly and accurately the price reflects news, the more efficient the market is. The idea is closely linked to the efficient market hypothesis, which was developed by economists in the twentieth century.
It comes in different strengths. The weak form says past prices cannot predict future prices, the semi-strong form says prices reflect all public information, and the strong form says they reflect even private information.
For investors, price efficiency has a practical meaning. If markets were perfectly efficient, studying company accounts to find undervalued shares would be pointless, and low-cost index funds would be the sensible choice.
If markets are less than efficient, careful research may find mispriced assets, though it is costly and hard. Efficiency varies between markets.
Large, heavily traded shares in developed markets are generally quite efficient because many analysts follow them and trading is cheap. Small companies, unusual bonds, property and some emerging markets tend to be less efficient, because information is scarcer and trading is slower.
For corporate managers, efficiency matters because market prices send signals. A share price that reflects reality helps with decisions on issuing shares, making acquisitions and judging performance.
Where efficiency is low, managers may need to rely more on their own valuation work. The concept is debated.
Bubbles, crashes and persistent patterns suggest that investors do not always behave rationally, and the study of behavioural finance explores this. Most practitioners accept that markets are efficient enough to make easy wins rare, but not so efficient that skill never matters.
In practice
Real-world examples.
Example
A large technology company releases results at 4:05 pm, and within minutes its share price has moved 6% to reflect the news. A retail investor reading the report an hour later finds no bargain. The information has already been absorbed by professional traders and computer systems. This illustrates a market that adjusts quickly.
Example
A small property company with few analysts and a thinly traded share price seems to trade 25% below the value of its buildings for years. An investor with local knowledge buys and benefits when a buyer eventually pays full value. The case shows how lower efficiency can create opportunities. It also shows the risk, because the investor had to wait years and could not easily sell the shares.
Example
A pension fund chooses a low-cost index tracker for its large-company shares, but hires specialist managers for small-company shares. The trustees reason that active research is more likely to add value where prices are less efficient. They review the fees every year. The trustees also ask each manager to report results after costs, so they can see whether the extra research paid for itself.
Case study
Seen in the real world.
Meridian Capital is a fictional investment firm used to illustrate the idea. It ran two funds, one investing in large listed companies and one in small, rarely traded companies.
After five years, the large-company fund had struggled to beat its index after fees, while the small-company fund had beaten its index by an average of 3% a year. The partners concluded that the second market was less efficient and offered more scope for research.
The illustrative firm continued to offer both products, but it told clients honestly that the large-company fund was priced as a low-cost option. The difference in efficiency drove how much it charged and how it explained its role. In its client letters, the illustrative firm explained that higher fees on the small-company fund paid for specialist research, and that results would vary from year to year.
Watch out
Common mistakes.
- Believing efficient means the price is always right. It means the price reflects available information, though information can be incomplete or misread.
- Thinking nobody can ever beat the market. Some investors do so for a time, but many struggle after costs, and past success is a weak guide to the future.
- Assuming all markets are equally efficient. Large markets are generally more efficient than small, thinly traded ones.
Questions
People also ask.
What is the efficient market hypothesis?
It is the theory that asset prices fully reflect available information, in weak, semi-strong or strong forms. It was developed and popularised by academic economists, and it remains a starting point for debate.
Why do bubbles occur if markets are efficient?
Critics say bubbles show that investors can behave irrationally, and economists still disagree about how to explain them.
How does price efficiency affect my choice of fund?
In efficient markets, low-cost index funds are hard to beat, while less efficient markets leave more room for skilled active managers.
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