Market efficiency is a term that you may have heard economists use. Some explanations of what this means can sound quite convoluted, but it really isn’t too hard an idea to grasp. Market efficiency is not only something that is important to economists but if you invest money then it is also something that might concern you too.
What is Market Efficiency?
The simplest explanation of market efficiency would be to say that it is a state of affairs whereby the price in the stock market reflects all the available information. This idea is based on the work of Eugene Fama who proposed the efficient market hypothesis (EMH). In this hypothesis it is stated that when all the information about the investments is known it will not be possible for any one investor to have an edge. After all this one investor will be only working with the same information as everyone else. The ideas of EMH have also been extended to other areas of life where the availability of information is important.
The implications of market efficiency are that it is incredibly difficult to beat the markets and expect returns that are above average. Of course for this to be true it requires that the market really be efficient, and there is most economists would deny that this is the real state of affairs. If it was the case then there would not be so many investors because why take risks if there is no real chance of a big return. It could be argued that markets are becoming more efficient though, because the rise of the internet is ensuring that information is quickly available to everyone no matter where they are located around the world. Perhaps as technology improves the markets will become more efficient.
Another implication is the closely associated with market efficiency is “random walk” theory. This theory views market prices as random and so impossible to predict. The implication of this then is that it is even harder for people to find an edge, and make a lot of money from investing. After all, if the market price is unpredictable then all investors are really doing is gambling.
Why is Market Efficiency Important?
The idea of market efficiency is very important for investors because it allows them to make more sensible choices. The only real way that they can get above average profits through investments in the different markets is by taking advantage of any abnormalities when they occur. When the market is running efficiently it will not be possible for investors to make above average profits, but any abnormalities can be exploited. Over time these abnormalities tend to be removed, but while they are there it is a good time to take advantage of them. The good news for investors is that there are many economists who argue that there will never be full market efficiency so there will always be a way to get an edge.