An efficient capital market is one in which security prices adjust rapidly to the arrival of new information and the current prices of securities reflect all information about the securities. Therefore, it is also called an informationally efficient capital market.
Why should capital markets be efficient? Competition is the source of efficiency, and price changes should be independent and random.
In an efficient market, the expected returns implicit in the current price of the security should reflect its risk. Investors buying the security should receive a return that is consistent with the perceived risk of the security.
In an efficient capital market the majority of portfolio managers cannot beat a buy-and-hold policy on a risk-adjusted basis. An index fund which simply attempts to match the market at the lowest cost is preferable to an actively managed portfolio.
Market Value versus Intrinsic Value
In an efficient market, the two values should be very close or the same. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value. Though market value and intrinsic value may differ over time, the discrepancy will get corrected as new information arrives.
In an inefficient market, the two values may differ significantly.
Factors Affecting a Market's Efficiency
Some factors contribute to and some impede the degree of efficiency in a financial market.
Transaction costs and information-acquisition costs should also be considered when evaluating market efficiency.
| Sp1993: "In an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value."|
This is slightly misleading - would be better if it read "the actual MARKET price of a security will be a good estimate of its intrinsic value"
Nitpicking but it might just avoid confusion
|cmacewen: Why is it misleading? The 'actual price' can be nothing other than the market price; there is no such thing as a non-market price.|
|ascruggs92: The only thing that's misleading is the belief of market efficiency. Markets have become more efficient over time, especially in the last 15 years due to the explosion of high speed internet and affordability of trading, but the belief that markets are fully efficient is one that's purely academic and only held by college professors who don't even have the balls to buy an index fund|
|Natk: @ascruggs92 - Markets probably aren't fully efficient (hopefully, as we would all be out of jobs) but many of the developed markets are probably somewhere around the semi-strong efficiency.|