Inefficient Market - Explained
What is an Inefficient Market?
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Table of ContentsWhat is an Inefficient Market?What Makes an Inefficient Market?Academic Research for Inefficient Market
What is an Inefficient Market?
According to the efficient market theory, an inefficient market refers to any market setting where the price of an asset doesnt actually represent its value. The Efficient market theory, which is also known as the efficient market hypothesis (EMH) states that the value of an assets is replicated in its price when it is showcased in an efficient market. For example, lets look at the stock market. In the stocks market, we happen to come across different shares, each holding different values which we assume are representatives of their true value. However, this isnt entirely true. In an efficient stocks market, the price of a share shows the true value of all publicly available information of such a company. Whereas, in an inefficient stocks market, there are no publicly available information (or a limited number), thus making it possible to bargain prices with the company. The efficient market theory has three different forms: the weak form, the strong form, and the semi-strong form. In the weak form, speculators or analysts suggests that an efficient market shows all the different historical publicly available information on a stock, including the financial data from the past. The semi-string form indicates that an efficient market shows historical and present available information about a stock. The strong form however includes non-public information to the details of the semi-strong form.
What Makes an Inefficient Market?
Like every investment and financial concept, the efficient market theory has its proponents and critics. The supporters of this model believe that outsmarting or outperforming the market can be quite risky due to the availability of high market efficiency. They suggest that investors follow or invest in passively traded funds like mutual funds and hedge funds since these companies make use of available information to trend with the market. Simply put, theyre not aiming to outperform the market. On the other hand, skeptics of this model believe that there is a holy grail which well-versed investors can master and use to surpass the market. Thus they suggest that active trading is better for investors than passively-managed funds. We however cannot conclude which side of the argument is wrong since weve seen situations where people cannot beat the market, as well as situations where people could outperform the market. Thus, we want to believe that both sides are quite right in their statements. Trading passively can work well for some markets, but fail totally for others, and same goes for active investments. For passively managed funds, they mainly stick to large cap stocks and indexes like the Dow Jones and the S&P 500. Whenever there is any news about these indexes and large cap funds, the public gets to know immediately without further delay. Most times, people refer to information provided by these large cap stocks as live news because they generally have an effect on the stocks prices at that point. However, for smaller stocks, news generally dont get disclosed as soon as there are information surrounding the stock or company. This makes it a good deal for active investors, as they get to bargain prices before ETFs and Hedges come in to purchase shares in these companies. This also makes it possible for investors to lose and gain excess amounts in an inefficient market. It is simply based on their risk level though. If the market were to be efficient, the chance of excess returns and losses would be limited since the price of stocks listed on exchanges would quickly match the value of the stock with each new information. From hindsight, all financial markets might look efficient, however, we can see that there are some inefficiencies as reflected in the Dotcom bubble bursts in the late periods of the 1990s and the market crash in that same period.