How can markets be inefficient

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. Like every investment and financial concept, the efficient market theory has its proponents and critics. For this to hold true -.

Proposition 1: The probability of finding inefficiencies in an asset market decreases as the ease of trading on the asset increases. To the extent that investors have difficulty trading on a stock, either because open markets do not exist or there are significant barriers to trading, inefficiencies in pricing can continue for long periods.

Proposition 2: The probability of finding an inefficiency in an asset market increases as the transactions and information cost of exploiting the inefficiency increases.

The cost of collecting information and trading varies widely across markets and even across investments in the same markets. As these costs increase, it pays less and less to try to exploit these inefficiencies. Investing in 'loser' stocks , i. Transactions costs are likely to be much higher for these stocks since-.

Corollary 1: Investors who can estabish a cost advantage either in information collection or transactions costs will be more able to exploit small inefficiencies than other investors who do not possess this advantage. Proposition 3: The speed with which an inefficiency is resolved will be directly related to how easily the scheme to exploit the ineffficiency can be replicated by other investors.

Based on this form of the hypothesis, such investing strategies such as momentum or any technical-analysis based rules used for trading or investing decisions should not be expected to persistently achieve above normal market returns. Within this form of the hypothesis there remains the possibility that excess returns might be possible using fundamental analysis. This point of view has been widely taught in academic finance studies for decades, though this point of view is no long held so dogmatically.

The semi-strong form of market efficiency assumes that stocks adjust quickly to absorb new public information so that an investor cannot benefit over and above the market by trading on that new information. This implies that neither technical analysis nor fundamental analysis would be reliable strategies to achieve superior returns, because any information gained through fundamental analysis will already be available and thus already incorporated into current prices.

Only private information unavailable to the market at large will be useful to gain an advantage in trading, and only to those who possess the information before the rest of the market does. The strong form of market efficiency says that market prices reflect all information both public and private, building on and incorporating the weak form and the semi-strong form. Given the assumption that stock prices reflect all information public as well as private , no investor, including a corporate insider, would be able to profit above the average investor even if he were privy to new insider information.

Investors and academics have a wide range of viewpoints on the actual efficiency of the market, as reflected in the strong, semi-strong, and weak versions of the EMH. Believers in strong form efficiency agree with Fama and often consist of passive index investors.

Practitioners of the weak version of the EMH believe active trading can generate abnormal profits through arbitrage, while semi-strong believers fall somewhere in the middle. For example, at the other end of the spectrum from Fama and his followers are the value investors , who believe stocks can become undervalued, or priced below what they are worth. Successful value investors make their money by purchasing stocks when they are undervalued and selling them when their price rises to meet or exceed their intrinsic worth.

People who do not believe in an efficient market point to the fact that active traders exist. If there are no opportunities to earn profits that beat the market, then there should be no incentive to become an active trader. Further, the fees charged by active managers are seen as proof the EMH is not correct because it stipulates that an efficient market has low transaction costs.

While there are investors who believe in both sides of the EMH, there is real-world proof that wider dissemination of financial information affects securities prices and makes a market more efficient. For example, the passing of the Sarbanes-Oxley Act of , which required greater financial transparency for publicly traded companies, saw a decline in equity market volatility after a company released a quarterly report.

It was found that financial statements were deemed to be more credible, thus making the information more reliable and generating more confidence in the stated price of a security. There are fewer surprises, so the reactions to earnings reports are smaller.

This change in volatility pattern shows that the passing of the Sarbanes-Oxley Act and its information requirements made the market more efficient.

This can be considered a confirmation of the EMH in that increasing the quality and reliability of financial statements is a way of lowering transaction costs. Other examples of efficiency arise when perceived market anomalies become widely known and then subsequently disappear. This index effect anomaly became widely reported and known, and has since largely disappeared as a result.

This means that as information increases, markets become more efficient and anomalies are reduced. Trading Strategies. Actively scan device characteristics for identification.