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What is market efficiency?

Market efficiency definition

The concept of market efficiency presupposes that if markets are efficient, all the available information is already reflected in prices. Therefore, nobody can beat the market, because there are no overvalued or undervalued securities.

The term was introduced by economist Eugene Fama in 1970 in his Efficient Market Hypothesis (EMH).

According to the EMH theory, an investor could not outperform the market, as prices completely reflect all available information about a particular asset. It means that no one has any advantage in forecasting a return on a stock price, for example, because no one has access to any information which is not yet available to everyone else.

In 2013, Eugene Fama was awarded the Nobel Prize in Economic Sciences.

Market efficiency meaning: non-predictability

Financial market information is not limited to financial news, market research and analyses. Everything, from economic and political to social events combined with investors’ perceptions of this information, is incorporated in stock prices.

In the efficient market, prices are random and not predictable. According to the Efficient Market Hypothesis, it makes a planned approach to investment impossible. Theory supporters prefer to invest in index funds that track the overall market performance and serve as examples of passive portfolio management.

Market efficiency at its core is the market’s ability to incorporate all the data that provides maximum opportunities to traders and investors. Whether the market is efficient is a topic of constant debate among practitioners and academics.

Market efficiency examples

There are 3 types of market efficiency: weak, semi-strong and strong. Together they constitute the elements of the Efficient Market Hypothesis (EMH).

  • The weak form of market efficiency 

The theory of weak form of market efficiency states that past security price movement can’t be used for predicting future price action. It presupposes that all the relevant information is already reflected in current prices and all the future price changes will be affected only by new information that will become available.

According to this hypothesis, strategies based on technical analysis can’t persistently bring above normal market returns. It believes that fundamental analysis is more effective.

  • Semi-strong form of market efficiency 

This theory assumes that stocks quickly absorb new information and investors can’t benefit above the market on this information. According to this form of market efficiency, neither fundamental nor technical analysis is efficient enough to bring superior returns, because even the fundamental data is already available to everyone and therefore, incorporated in the asset’s price. Only private information unavailable to market yet will be useful to get a trading advantage.

  • The strong form of market efficiency 

This theory states that market prices incorporate and reflect all the information, both private and public. According to the strong form of market efficiency theory, stock prices already reflect all the information (private and public), which means that no one, even a corporate insider, will not be able to profit more than an average investor or trader.

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