The Concept of Market Efficiency | CFA Level I Equity Investments

In this lesson, we’ll cover the definition of an efficient market, the difference between market value and intrinsic value, and the factors that affect a market’s efficiency.

An Efficient Market

An efficient market is one where asset prices reflect new information quickly and rationally. Statistically speaking, this means that current market prices are unbiased estimates of their values. The expected return on any asset is simply the equilibrium return necessary to compensate investors for the risk regarding its future cash flows.

Basically, in a perfectly efficient market, “you can’t beat the market!” Investors should adopt a passive investment strategy, buying a broad market index of stocks and holding them. Active investment strategies will underperform due to transaction costs and management fees. But not everyone believes that markets are perfectly efficient, leading to plenty of active investors who believe they can generate positive risk-adjusted returns by exploiting market inefficiencies.

Measuring Market Efficiency

One way to measure a market’s efficiency is to determine the lag between the time new information is disseminated and the time prices reflect that information’s implications. In some highly efficient markets, like foreign currency markets, this lag can be as short as a minute.

If there is a significant lag, informed traders can use the information to potentially generate positive risk-adjusted returns.

EXAMPLE: If Pineapple Corp announces that profits have grown 10%, but the general expectation was for a 25% growth, the earnings were below expectations and should cause the stock price to fall.

Market Value vs. Intrinsic Value

The market value of an asset is its current price. The intrinsic value or fundamental value is the value that investors would place on an asset if they had a complete understanding of its investment characteristics.

In a perfectly efficient market, investors can fully and quickly react to new information, and the market value should reflect the actual intrinsic values. In practice, markets are neither perfectly efficient nor completely inefficient. Market efficiency should be viewed as a continuum between completely inefficient and perfectly efficient.

Factors Affecting Market Efficiency

The degree of efficiency can vary across countries, time, and market types. The following factors affect the degree of market efficiency:

1. Number of market participants: The more investors, analysts, and traders who follow a market, the more efficient it is.
2. Availability of information: The more information available to investors, the more efficient the market. Developed markets like the New York Stock Exchange have greater efficiency than emerging markets due to the availability of information.
3. Impediments to trading: Arbitrage, high transaction costs, and lack of information can limit trading activity and allow mispricing of assets to persist.
4. Transaction and information costs: Lower transaction costs and information acquisition costs can improve market efficiency.

That’s it for this lesson on the concept of market efficiency. We’ll continue our discussion in the next lesson, where we’ll explore the different forms of market efficiency.