What is Market Efficiency?
Market efficiency is a phrase we use to describe how much information is incorporated into current market prices.
Let’s quickly pause here to really think through what exactly “information” is referring to. Think of information as every piece of data that is out there in the world which relates to a particular company, as well as all information which exists on its competitors and the broader macroeconomic environment in which the company operates. As you can tell by now, we start with a very broad and slightly mind-blowing definition of “information”!
To make things easier, lets simplify this “information” into 3 broad categories:
Historic: This refers to all information which has been made available throughout the past
Public: This refers to all information which is publicly available right now
Private: This refers to all information which is privately held (known only to a few individuals, usually within the company)
We can combine the above 3 categories of “information” to come up with different levels of market efficiency:
All historic + publicly available + private information is reflected into stock prices
In other words, ALL available information - past, present and private, is accurately reflected in the price of a stock
We call this “Strong form efficiency” - because everything you could possibly know about the company is already known and reflected in its stock price - only genuinely new information would move the stock price higher or lower as everything else has already been accounted for!
In this situation, something like insider trading wouldn’t be able to make you any additional profits, as even that “inside” or private information has been reflected in a company’s share price. Now - we know this isn’t really true given the number of “insider trading” cases and prison sentences we see being handed out on the news!
All historic + publicly available information is reflected into stock prices
In other words, all PUBLICLY available information - both past and present, is accurately reflected in the price of a stock
We call this “Semi-strong form efficiency” - because everything which is publicly known about a company is reflected in its stock price - only genuine new information could move the stock price higher or lower, OR someone acting on private information could make (illegal) profits by trading on that private information
This sounds more familiar, right? We see people in the real world carrying out a lot of stock analysis to trade in the market - a lot of which includes looking at a company’s financial statements (we call this fundamental analysis)
You’d be right in thinking that this is a fairly accurate description of the real world most of the time. However, just because we love finance - what if we do a little thought experiment and remove the “publicly available” information from our definition of semi-strong form efficiency?
All historic information is reflected into stock prices
In other words, only previously released information is accurately reflected in the price of a stock - everything that is publicly or privately known today is not reflected in the share price
We call this “Weak form efficiency” - i.e. markets aren’t doing a very good job of incorporating information into stock prices, so are not very efficient!
But what does this all this mean? Well, if all historic information is reflected in a stock price, you shouldn’t be able to look at price charts and accurately predict whether the stock price will move up or down (we call this technical analysis) - because when you break it down, a price chart is just a tool which shows you historic information about a share price - and if all this information is already reflected in a share price, you couldn’t possibly find anything new there which might give you some kind of edge over others!
Still reading? We salute you 👏🏼👏🏼👏🏼 But why should you care?
Well, turns out that different levels of efficiency in any given financial market have varying implications for the effectiveness of your investment strategies:
If markets are strong or semi-strong form efficient, we can assume that no amount of analysis will really give you an edge (unless you are illegally trading on insider information) - as all available information is already reflected in the stock price. In this case, you are probably better off taking a passive approach to investing
If, however, markets are only weak-form efficient, some fundamental analysis might uncover information which hasn’t yet been incorporated into the stock price and can be used to buy/sell shares in order to profit accordingly. Active investing / stock picking could really boost your investment returns in this case
Finally, if markets aren’t even weak form efficient (i.e. all historic information isn’t incorporated into stock prices), technical analysis might uncover information which could be used to buy/sell shares in order to make a profit. Active investing could again boost investment returns in this case!
While you’re here - we’ve also dived a little deeper into Active vs. Passive Investing - depending on the level of market efficiency in any given stock market, it might be more / less beneficial to invest via Active or Passive strategies!
Please know, the value of investments can go up as well as down and you may receive back less than your original investment, meaning, when investing your capital is at risk.
Disclaimer: At Evarvest we believe in making investing and investment education more accessible, but we don’t provide investment advice and individual investors should make their own decisions. While we try our best, we cannot ensure the accuracy of the information we provide.
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