Efficient market pricing is the theory that all known information is already reflected in current securities prices.
Efficient securities market pricing has become very widely accepted within the investment community. The preponderance of evidence is that securities markets are efficient and tend to reflect available information. Whether you believe markets are efficient is very important to your decisions about appropriate investment strategies and tactics.
On one end of the spectrum, if you believe that market prices fully reflect available information, then you are more likely simply to accept the current price as the fair market value. Market efficiency means that even if you were to engage in significant research you would only be reanalyzing information that has already influenced enough other market participants to be fully reflected in the current price.
If you do not believe that markets are generally efficient, you are much more likely to engage in research in an attempt to find overlooked or improperly understood information. Your objective would be to use this unappreciated information to identify securities that are not yet properly priced by the market. You would implement trading strategies in the hope that they would allow you to capitalize upon that information and earn exceptional profits.
Efficient market theory gives rise to an often-repeated investment joke that comes in many different flavors. In general, two economists are walking down the street and both see a $100 dollar bill on the ground. One asks the other, “should I pick it up?” The other says, “Don’t bother, the markets are efficient and therefore someone else already has.” This joke reveals some of the misunderstandings that surround efficient market theory.
Markets can be efficient if they tend to reflect fully the available information in securities prices on average.
Across different securities and from time to time price inefficiencies may crop up here and there, and active market participants can and will move in to profit from these inefficiencies. By picking up the occasional $100 dollar bill found on the ground, traders – or the economists in the joke – make the markets more efficient.
If securities markets are efficient, then positive and negative price inefficiencies will tend to be small and cancel each other. However, if profits net of analysis and trading costs on information-based trading strategies are significant and sustained over a long period, then this might be an indication that the market is less [...]