What makes a market efficient?

We explained in another article that price doesn’t always equal value and, in fact, it rarely does.

When there are mispricings, however, there are normally attentive investors operating in the market that will act to either buy or sell the asset, depending on whether the price was above or below the investors’ estimate of fair value. When there are lots of attentive investors, with access to a lot of high quality information, these mispricings are ‘corrected’ fairly quickly. The opportunity for each individual investor to take advantage of mispricings, therefore, is fairly limited. We call such a market an ‘efficient market’. In an efficient market, ‘active’ investors – those who seek to buy underpriced assets and sell overpriced assets – have limited scope to perform better than the overall market. When investing in an efficient market, it is advisable to simply buy the whole market, for example using an index tracker fund, rather than trying to select assets (e.g. stocks) within the market. Large, closely-followed, developed economy stock market indices such as the S&P500 in the USA are typically considered to be very efficient.

Some markets, such as small stocks in a given country, or emerging economy stock markets, are less efficient. This could be for a number of reasons. The information available about assets within a market might be unreliable, unclear or untimely; there might not be many investors keeping an eye on certain assets within a given market; or there simply may be more disagreement about what the fundamental value of a given asset is. In these cases, the opportunity for active investors to perform better than the overall market is higher. It may well pay for investors to attempt to buy ‘good’ assets and sell ‘bad’ ones. In less efficient markets, therefore, it may be advisable to take an active approach to investing. For everyday investors, that will mean investing in an actively managed fund, rather than trying to do the asset selection themselves.

A famous investment theory, known as the ‘efficient markets hypothesis’ claims that all markets are efficient. That is, all markets reflect true and fair information in their price. Established consensus these days – which we agree with – is that some markets are more efficient than others.