Subject 1. The Concept of Market Efficiency

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.

  • A large number of competing profit-maximizing participants analyze and value securities, each independently of the others.
  • New information regarding securities comes to the market in a random fashion, and the timing of an announcement is generally independent of others.
  • Competing investors attempt to adjust security prices rapidly to reflect the effect of new information. The price adjustment is unbiased: sometimes the market will over-adjust and other times it will under-adjust; you cannot predict its behavior.

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

  • Intrinsic value is the true, actual value of an asset. It is what the asset is really worth.
  • Market value is the price of an asset. It is what buyers are willing to pay for the asset.

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.

  • The number of market participants. The more investors and analysts that follow a financial market, the more efficient it becomes.
  • Information availability and financial disclosure. All investors should have access to the necessary information to value securities. This should promote market efficiency.
  • Limits to trading. Some researchers argue that restrictions on short selling impede market efficiency.

Transaction costs and information-acquisition costs should also be considered when evaluating market efficiency.

User Contributed Comments 4

You need to log in first to add your comment.
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.