Category: LOS – describe market efficiency and related concepts, including their importance to investment practitioners

Information plays the most important role in efficient markets.

Prices change when investors receive new information and believe that the information affects the value of an asset. This information may be related to earnings, interest rates, economic growth, inflation, government policy, or company-specific news.

In an efficient market, information is incorporated into prices through trading.

Example:
Suppose inflation rises from 5% to 7%. Investors may expect the central bank to increase interest rates. Higher interest rates can reduce company profits and make borrowing more expensive.

Because of this, investors may sell stocks. If many investors sell, stock prices may fall.

For example, a stock trading at ₹900 may fall to ₹840 after the inflation data is released.

This shows how economic information can affect asset prices in an efficient market.

Short selling is a transaction where an investor sells a security they do not own by borrowing it, expecting to buy it back later at a lower price.

Short selling helps market efficiency because it allows investors to act when they believe a security is overvalued.

Example:
Suppose a stock is trading at ₹1,000, but an investor estimates its intrinsic value to be ₹800.

The investor may short sell the stock at ₹1,000. Later, if the price falls to ₹800, the investor buys it back.

Profit per share:

₹1,000 – ₹800 = ₹200

If the investor short sells 100 shares, total profit will be:

₹200 × 100 = ₹20,000

Short selling adds selling pressure to overvalued securities, helping prices move closer to fair value.

However, if short selling is restricted, overvalued stocks may remain overpriced for a longer time.

Trading activity means how frequently securities are bought and sold in the market.

Higher trading activity usually improves market efficiency because information gets reflected in prices through trades. If trading activity is low, prices may not adjust quickly.

Example:
Suppose a stock has positive news and its fair value increases from ₹300 to ₹360.

If the stock is actively traded, many investors may buy it, and the price may move quickly toward ₹360.

But if only a few shares are traded each day, the price may move slowly from ₹300 to ₹320, then ₹340, and later ₹360.

This slow price movement shows lower market efficiency.

So, active trading helps prices reflect information faster.

Transaction costs are the costs investors pay when buying or selling securities. These may include brokerage, taxes, bid-ask spread, exchange fees, and other charges.

High transaction costs can reduce market efficiency because investors may avoid trading even when mispricing exists.

Example:
Suppose a stock is trading at ₹500 in one market and ₹508 in another market.

The price difference is:

₹508 – ₹500 = ₹8

But if the total transaction cost is ₹10 per share, the investor will not trade because the cost is higher than the possible profit.

Net profit:

₹8 – ₹10 = -₹2 per share

In this case, the price difference may remain because it is not profitable to correct it.

So, markets are efficient only within the limits of transaction costs.

An efficient market is a market where asset prices reflect available information quickly and rationally.

This means that when new information enters the market, investors analyze it, revise their expectations, and trade accordingly. As a result, the price of the asset adjusts to reflect that information.

In an efficient market, it is difficult for investors to earn abnormal profits consistently because the market price already includes most available information.

Example:
Suppose a company stock is trading at ₹500. The company announces that its profit has increased by 25%, which is better than expected. Investors may now believe that the company will generate higher future cash flows.

As more investors start buying the stock, the price may quickly rise from ₹500 to ₹560. This increase happens because the market has adjusted the stock price based on the new information.

So, an efficient market does not mean prices are always correct. It means prices respond quickly to information.

Market efficiency differs across markets, countries, and securities.

Large and liquid markets are usually more efficient because they have more participants, better disclosure, and lower trading costs. Smaller or less developed markets may be less efficient because information may be limited and trading activity may be low.

Example:
A large company may be followed by 60 analysts and thousands of investors. If new information is released, the stock price may adjust within minutes.

But a small company may be followed by only 2 analysts. If new information is released, the stock price may take days or weeks to adjust.

This shows that market efficiency is not fixed. It depends on the structure, information flow, participants, and costs in the market.

Market efficiency is important because it affects how investors make investment decisions.

If a market is highly efficient, asset prices already reflect available information. In such a market, it becomes difficult for investors to find undervalued or overvalued securities. This reduces the chances of earning extra returns through analysis alone.

That is why many investors prefer a passive investment strategy in efficient markets. Passive investing means buying and holding a broad market portfolio instead of trying to beat the market.

Example:
Suppose an investor spends ₹20,000 on research and advisory services to select stocks. After one year, the selected stocks generate a return of 11%. During the same period, a market index fund gives a return of 10.5%.

At first, the active strategy looks better. But after deducting research cost, transaction cost, and management fees, the actual return may fall below the index fund return.

This shows why passive investing can be preferred when markets are efficient.