Methodology

Stocks

Module 3

What is Market Efficiency?

Stock prices change in response to information, which could broadly be specific to a country, sector or company. Market efficiency is about how efficiently this information is priced into a stock, in terms of the speed and accuracy of how the information is reacted to. 

If a stock market is efficient, then all relevant information has already been priced in. This makes it difficult to achieve an abnormally high return as there are no stocks that are under or over-valued.

If a stock market is not efficient at all, then it would mean that information does not drive stock prices at all. This essentially means that stock prices move completely randomly and cannot be predicted.

There are three types of market efficiency: weak form, strong form and semi-strong form. All of which will be discussed individually in the upcoming lessons.

Why is market efficiency important for investors?

Whether stocks are highly efficient or not is important to investors, as it influences the approach that they take to investing.

If a stock is highly efficient, then it means that an investor cannot gain any advantage by doing research on a company.

This is because information about the company would be priced into a stock at such a high pace, that the research that an investor would do would become outdated really quickly.

Likewise, if a stock is highly inefficient, then it also means that an investor cannot gain any advantage by doing research on a company. Instead, this time it happens because the stock price is changing for completely random reasons. This means that information has no influence on the performance of a stock.

For instance, if a stock announces record profits, it would be irrelevant as the stock moves in a completely random way. This would be unusual as record profits typically results in a huge increase in the stock price of a company.

Therefore, in both situations, the investors would be better off just buying stock in a company and holding it for the long term. At the same time, if a stock is completely random, there may be little benefit in investing at all. Luckily, these cases are incredibly rare.

Market efficiency and stock markets

The level of efficiency that a stock market experiences varies from one market to another. Some stock markets will be more efficient than others.

This happens for a number of reasons, including how popular the stock market is, how expensive it is for investors to trade in that market or whether reliable information is actually available or not.

As a consequence, a developed stock market, such as the New York Stock Exchange, is likely to be more efficient than a less developed stock market.

This is the case because the New York Stock Exchange lists some of the most famous companies in the world, with millions of investors buying and selling them everyday. Investing in the NYSE is affordable in most countries, with a lot of information being readily available to most investors.

As a consequence, stocks listed on the NYSE tend to be efficiently priced.  So, from an investors perspective, investing in more developed stock markets is likely to provide a more stable environment in terms of market efficiency, as it is easy to match stock market changes with relevant information.

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