What does market efficiency mean?

Posted by TEBI on April 8, 2024

What does market efficiency mean?



Market efficiency is the idea that security prices, such as stocks and bonds, generally reflect all publicly available information. The financial historian MARK HIGGINS outlines what ordinary investors need to know about this important principle of investing.



Robin Powell: A crucially important principle investors need to understand is market efficiency. It was first devised by the economist Eugene Fama, and helped to earn him a Nobel Prize. But what exactly does it mean? Mark Higgins is a financial historian.

Mark Higgins: Market efficiency essentially means that the prices of securities, such as stocks that are traded on exchanges and bonds, generally reflect all information that is available to the public. And from a practical perspective, this means that there are very few investors that can beat the market by identifying misplaced securities because the constant buying and selling really makes the price as accurate as it can be, given all information available.

RP: Simply put, market efficiency means that it’s very hard to identify, in advance, stocks and funds that will outperform. Investors should focus instead on simply capturing the return of the broad market.

MH: I think a lot of people think of market efficiency as being a relatively recent phenomenon because it wasn’t really described mathematically until 1970, by Eugene Fama. But the reality is that market efficiency existed for a very long time, because it’s really a fundamental principle of markets. It’s ultimately a product of an ensuring mathematical principle. It’s known as the wisdom of the crowds, and it was a concept that was first documented by Francis Galton in 1907. But even before Galton, the principles of market efficiency were actually known to the – they were called stock operators on Wall Street as far back as the mid-1800s. They knew it was very hard to profit, if not impossible to profit, from just analysing securities, which is why – and I talked about this in the book – they made their money from engaging in things like market manipulation and insider trading.

RP: As Mark Higgins says, it’s very difficult to beat the wisdom of the crowd. And remember, you’re not just up against ordinary investors. You’re also competing with an asset management industry that has grown hugely in recent decades and continues to do so.

MH: Globally, active managers have about 115 trillion, and it’s projected to grow to almost 150 trillion by 2027. So, even though the evidence is overwhelming that most investors do not benefit from active management, it continues to grow. Index fund investing is growing, but active management… maybe it’s slowed down active management a little, but it’s still an enormous industry.

RP: In summary, financial markets do an excellent job of absorbing all the very latest information about the value of different securities. Yes, you could try to beat the stock market. But, in the long run, the odds are stacked against you.


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