Quick definition Market efficiency is the degree to which prices reflect all available information. In perfectly efficient markets, prices always reflect true value and no trader can consistently beat the market. What it is There are three levels of market efficiency: - Weak-form: prices reflect historical price information - Semi-strong: prices reflect all public information - Strong-form: prices reflect all public and private information (impossible to achieve) Most US markets are semi-strong efficient; prices reflect public information quickly but may not reflect insider information. Why it matters Market efficiency affects trading strategy. If markets are efficient, active trading cannot consistently beat passive buy-and-hold. If markets are inefficient, active traders can profit from mispricings. Academics debate market efficiency. Some believe markets are efficient; others believe there are exploitable inefficiencies. Efficient market hypothesis (EMH) The EMH states that markets are efficient and prices always reflect available information. If true, active management cannot beat the market. The debate over EMH is fundamental to finance. Market efficiency and microstructure Market microstructure affects efficiency. Venues with deep liquidity and many participants have better price discovery and higher efficiency. Thin markets with few participants are less efficient. Practical example Company announces earnings that are surprisingly good. In an efficient market, the price rises immediately, within seconds. An inefficient market might take minutes or hours to adjust. A trader with better information processes earnings faster and profits before prices adjust. This trading activity pushes prices toward efficiency. Evidence Evidence on market efficiency is mixed. Major price moves sometimes appear to be mispricings (bubbles, crashes) that persist. But many academic studies find that markets are mostly efficient. See also - Price Discovery - Information Asymmetry - Market Quality - Weak-Form Efficiency
