What is market efficiency?

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December 04 2018
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Market efficiency is the condition wherein a financial market operates well due to various circumstances that bolster the confidence of investors. This is achieved when the price of securities is accurately reflected on the value of the issued securities and when investors make rational investment decisions based on up-to-date information.

In essence, market efficiency measures a market’s ability to provide necessary information to investors that allows them to maximise opportunities without affecting transaction costs.

What do efficient markets look like?

According to the efficient market hypothesis (EMH), outperforming the market isn’t possible and bubbles and price anomalies shouldn’t exist, as securities are accurately priced according to all of the information available to investors. The accessible information would pave the way for the market prices to quickly correct themselves and take away the opportunity for some investors to profit more than others.

In an efficient market, undervalued and overvalued stocks do not exist because all securities are priced according to available up-to-date information. Historical prices thus have no bearing on the current day’s trading and the majority of investors would prefer market trackers like index funds.

Market performance and prices move randomly because the current day’s price is unrelated to historical prices. Instead, price movements are based on the information that investors have during the trading day. This means that it’s possible for share prices to abruptly change from the previous trading day’s close to the current day’s open.

Imagine a market where all investors have access to the same information and make investment decisions rationally. Since they have similar goals and access the same information, they would tend to make similar investment decisions. There would be no “better informed” investors who can short a stock to profit from a dead cat bounce or a bubble.

Degrees of market efficiency

As can be seen in real-world markets, not all investors agree with the EMH and those that do have varying opinions with regard to how efficient markets can get.

There are three classic divisions of market efficiency: strong, weak and semi-strong.

Strong form
The strong form of market efficiency is composed of investors who believe that the market price of securities already reflects the correct and fair value of its underlying assets. In this sense, even those who supposedly have inside information cannot generate great profits.

As previously mentioned, these investors tend to favour passive strategies by investing in market trackers.

Weak form
The weak form of market efficiency, on the other hand, is composed of investors and practitioners who believe that market prices don’t necessarily reflect the correct value of underlying assets despite the availability of information.

Investors who practice the weak form are typically value investors who believe that securities can be undervalued or overvalued. These investors use value investing to reap profits from such securities.

Semi-strong form
Investors who fall under the semi-strong form of market efficiency believe that, while some securities are fairly valued, others can be undervalued or overvalued. In this sense, they have a balanced view of investing and may prefer a mix of assets and strategies.

However, just like in other markets, there are still anomalies that may occur.

Does Australia have an efficient market at present?

Several studies have assessed Australia’s market conditions and most have found that it is consistent with weak and semi-strong market efficiency, which means that the Australian market is fairly balanced.

The Australian Investments and Securities Commission is responsible for maintaining market integrity and supporting market efficiency.

About the author

Louise is a content producer for Momentum Media’s nestegg who likes keeping up-to-date with all the ways people can work towards financial stability in 2019. She also enjoys turning complex information into easy-to-digest, practical tips to help those who want to achieve financial independence.

About the author

Louise is a content producer for Momentum Media’s nestegg who likes keeping up-to-date with all the ways people can work towards financial stability in 2019. She also enjoys turning complex information into easy-to-digest, practical tips to help those who want to achieve financial independence.

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