Lesson 1

Market Efficiency

If you studied our beginners guide, you will know that stock prices change in response to information.

That information could broadly be country-specific, sector-specific or company-specific.

A key element of how information affects the stock market is called market efficiency, which is basically a measure of how efficiently information is priced into the market.

If a stock market has very little market efficiency, it’s a bad situation because the stock market becomes more and more random.

Likewise, if the stock market has very high market efficiency, this means that the stock market is very predictable.

Market efficiency is incredibly important for investors because it can affect the extent to which logic can be applied to make sound investment decisions.

If the market is completely random and doesn’t react efficiently to new information, it may be impossible to invest effectively.

Equally, if the market is very efficient, attractive investment opportunities may be short lived or difficult to come across.

There are three different types of market efficiency: weak, semi-strong and strong. We will explain what each type is in more detail below.

Weak market efficiency

The weak version of market efficiency assumes that past information does not affect current stock prices, therefore it is impossible to use the past to predict what is going to happen in the future.

As a consequence, investors that subscribe to the weak market efficiency perspective, believe that looking at the stock chart is a complete waste of time.

They believe that it is impossible to identify patterns in past stock data to predict future patterns.

Weak market efficiency is often referred to as random walk theory, which as the name suggests, assumes that the stock market is completely random.

Investors that hold a random walk perspective typically believe that is not possible to outperform the overall stock market.

For that reason, many believe that the best thing to do is to accept the return of the market only, as everything else is nonsense.

As you might imagine, most professional investors do not subscribe to this point of view.

Strong market efficiency

Unlike weak form market efficiency, strong form market efficiency does believe that all past information is priced into the market.

In fact, strong form market efficiency believes that all relevant information is fully accounted for in stock prices, regardless of whether the information is publicly available or not.

This means that the value of the stock mirrors the true value of each company with full efficiency.

Individuals that believe in strong market efficiency claim that even insider information isn’t useful in terms of gaining an advantage in the market because that information is already accounted for, even though it is not publicly known.

Strong form market efficiency implies that there is no point in carrying out research because all of the information is priced into the stock at all times. Therefore, investors cannot gain an advantage through hours or research or analysis.

Instead, those that believe in strong form market efficiency suggest that the best approach is to buy and hold stocks to get the best return.

Just like weak form market efficiency, the majority of professionals do not believe in strong form market efficiency.

Semi-strong market efficiency

The form that most finance professionals believe to be the reality is semi-strong market efficiency.

Semi-strong market efficiency is basically a hybrid version of weak form and strong form market efficiency.

Semi-strong market efficiency assumes that the stock market does price in new information but that there is a short delay in accounting for it. This provides investors with a short window of time to gain an advantage in the market.

Semi-strong market efficiency suggests that stock prices account for all publicly available information, not information that is held privately.

For that reason, semi-strong market efficiency assumes that the only way to make above average returns is to obtain and utilize private information.

This is why companies like Bloomberg sell data feeds at extremely high prices. The belief is that your return in the market depends upon your speed in reacting to new information.

Investors that can’t afford expensive data feeds are at a disadvantage, according to semi-strong market efficiency.

How to measure market efficiency?

Although a common belief is that the stock market is semi-strong efficient, there’s nothing to say that it can’t change over time.

Measuring market efficiency is tricky but a simple way is to observe how quickly the market reacts to information.

This method is not particularly scientific though because you’d have to be aware of every publicly or privately available piece of information that could affect a stock price, which most new investors will not have access to.

In the academic world, proxies are commonly used to measure market efficiency. For example, company announcements are often used a proxy for information that is publicly available.

This information is often utilized in a complex multiple regression model to measure market efficiency to an extent. Many studies are imperfect and not 100% reliable.

In reality, some stocks are more efficient that others, which often is driven through popularity.

If a stock is very popular, the market can very quickly price in new information. On the other hand, if a stock is not particularly popular, it can take time for information to impact upon the stock price – which is known as the neglected stock effect.

A concern for the future is that some stocks will receive a lot of attention and be very efficient, while other companies are neglected and have no efficiency at all.