Market Efficiency
Candlefocus EditorThe concept of market efficiency has been a heavily debated topic in academic circles for decades, with scholars of economics and finance offering both theories and empirical studies to support the notion that financial markets are, at least to some degree, efficient. Historically, the main advocates of market efficiency have been the efficient-market hypothesis (EMH) and random-walk hypothesis (RWH).
The EMH suggests that financial markets are efficient and react instantly to new information, while RWH states that the incessant changes in a security's price are a result of random chance and are unrelated to any form of information or knowledge.
There are three levels of market efficiency that financial theorists distinguish. The first is the weak Form of Market Efficiency which states that current stock prices fully reflect all B past Marketinformation. This suggests that past market prices and trading volumes should be of little value to investors wanting to make sound decisions. The second is the semi-strong form of market efficiency. This states that current stock prices reflect not only all past market information but also all publicly available information. This suggests that systematic analysis of both financial and non-financial information can be of little value to investors seeking above seasonal returns. The third is the strong form of market efficiency. This proposes that current stock prices take into consideration all types of information, including public and private information. This suggests that any kind of research or analysis is of no value to investors seeking abnormal returns.
There are many benefits from efficient markets. For one, efficient markets allow for more accurate capital-investment decisions, since it's easier to tell whether or not a particular investment will generate positive long-term returns. Additionally, efficient markets tend to be more liquid since investors are more willing to buy and sell assets when it's easy for them to establish a fair price. Finally, efficient markets tend to be more efficient in terms of the allocation of resources since investors can usually identify investments with the highest expected returns.
In an efficient market, arbitrage is impossible, meaning a trader cannot make above-market returns simply by buying certain assets and selling others; any current price discrepancies are quickly eliminated due to the influx of more trading. Thus, investors and traders must instead attempt to out-perform the market by analyzing the market and successfully anticipating what it will do next, in order to make trades that return more than the market benchmark. This can be difficult as, by definition, if the market is efficient, all available, relevant information is already priced into the assets, so it is hard to make decent returns from trading on the information.
In summary, market efficiency is the concept that the current prices of assets reflect all the available, relevant information about those assets. To achieve market efficiency, the quality and the amount of information available to traders must increase. This reduces opportunities for arbitrage and above-market returns, which is important for asset pricing and resource allocations. However, it also makes it difficult for traders to outperform the market due to the efficient pricing of all available, relevant information.