What Is an Efficient Market?

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What Is an Efficient Market?

So you think you can beat the market? According to the efficient market theory, you can’t.

Here’s why

In an efficient market, a security’s current price reflects all the information available on that security. Prices react immediately and correctly to new information. Only new information can change the price. Price changes not based on new information are totally random. Therefore, past pricing trends cannot be used to predict future price changes. According to the efficient market theory, the best you can hope for is to reproduce market averages.

When new information hits the market, investors buy and sell securities in response to the news, creating price changes. The current market price is the best estimate of the investment’s value.

The weak form of the theory

There are three different levels of efficiency a market can obtain. When the market is said to be in a "weak" form of efficiency, all historical data, such as rates of return and trading volumes, are reflected in its security prices. In a weakly efficient market, market timing and technical analysis will not work and investors are advised to hold onto their investments for the long term.

The semi-strong form of the theory

If a market is in a semi-strong condition, all publicly available information (such as financial reports) is reflected in the security prices. In a semi-strong market, the conditions of a weak market apply, and now the analysis of company information (fundamental analysis) will also not work. This includes non-market information such as dividend announcements and news about the economy.

The strong form of the theory

When a market reaches strong efficiency, all possible information is reflected in security prices. A strong market encompasses both the weak and semi-strong market forms. All types of analysis, including insider information, are useless in trying to predict a security’s price when a market is strongly efficient.