Finance Glossary

What is Market Efficiency?

What is Market Efficiency?

 

Market efficiency is the degree to which the market reflects all available, relevant information. The concept of market efficiency was popularized in the 1970s by economist Eugene Fama. According to Fama’s efficient market hypothesis (EMH), stock prices and prices of other securities have a close relationship to all available information relevant to the market and are traded at a fair value. This means that a stock cannot be undervalued, and that it is impossible to “beat the market.”

Investors who believe in Fama’s idea of strong efficiency will employ a passive strategy, investing funds in a popular index. Investors who disagree with Fama’s theory believe that the market has weak efficiency, meaning that not all information is reflected in a stock’s price, which is primarily a reflection of past prices. These investors will employ a more active strategy, finding emerging stocks that may be undervalued, such as a hot new tech company. There is also a concept between these two extremes known as semi-strong efficiency, meaning that prices reflect all public information, but not all private information.

Though there is mush disagreement about the degree to which the market as a whole is efficient, there is historical precedent that indicates more transparency and availability of information leads to greater market efficiency. One example is the Sarbanes-Oxley Act of 2002 created in the wake of the Enron scandal. The legislation required more transparency from publicly traded companies, which in turn led to less equity market volatility after the release of a firm’s quarterly report.

 

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