Why is it important that markets are efficient? Is market efficiency even possible? And, what limitations are standing in the way of reaching that noble goal?

Efficient markets are those where informational efficiency exists. What is informational efficiency? Simply, when new information enters the capital markets arena, such as change in earnings, or dwindling demand for a product, or soaring gross domestic product (GDP), an efficient market will “digest” that information within a few minutes, and sometimes even seconds. However, if only partial information is reflected, or if it takes days for it to fully “sink in,” then the markets are said to be informationally inefficient.

Why Even Care?

Markets set prices, while efficient markets set prices efficiently. Setting prices efficiently also means setting prices correctly. More importantly, if and when set correctly, prices determine how resources are to be distributed among market participants.

For example, if a product, project or financial instrument has a price that is too low compared to its cost, investing in it is likely to result in a failure. On the other hand, if prices are too high, capital or resource could unjustly end up with an overvalued end user. Of course, if a market is efficient and its prices are set correctly, allocation of resources is more likely to be fair and successful, thus leading to economic growth and industrial development.

Can Capital Markets Be Truly Efficient

Perfectly efficient markets are unattainable. While degrees of market efficiency (weak, semi-strong and strong form) are broadly attainable, there are three limitations potentially standing in the way of eliminating pockets of market inefficiencies:

• cost of information
• cost of trading, and
• limits of arbitrage.

Cost of Information

The idea that markets are informationally inefficient is relatively simple to explain. If we assume that markets are informationally efficient, new information should be instantly reflected in prices. But if information is instantly reflected in prices, then market participants have little to no incentive to search, generate, or report such new information. Hence, such information, which no one wants to find, release or analyze, in effect has no true value, it is not reflected in prices, and thus creates market inefficiencies.

Cost of Trading

While trading, market participants incur costs such as time, brokerage costs, overhead costs, etc. If a trader operates within a high cost environment, he or she is likely to keep prices higher to cover at least some of those costs, while maintaining his or her profits at certain levels. Obviously, traders need to achieve a required rate of return from their activities in order to keep on trading and to keep the markets as efficient as possible.

Limits of Arbitrage

Arbitrage keeps the market at certain levels of efficiency because their presence in the market ensures the law of one price is maintained and that temporary mispricings are corrected quickly.

However, arbitrageurs are not the all-powerful “policemen” of the capital markets. Anecdotal evidence shows that noise traders can be quite capable of influencing mispricings, even to the point of greater divergence. If that happens, arbitrageurs could find themselves on the wrong side of the market and be forced to close their positions too early before mispricings could have been corrected.

In addition, it is virtually impossible to identify two mispriced assets with precisely the same level of risk. Most of the time, for arbitrageurs to take advantage of temporary mispricings at no risk, assets must be at least of comparable risk level. If not, structuring the deal to correct temporary mispricing at no risk might not even be possible.

Finally, contrary to popular opinion, arbitrageurs do not have access to huge pools of money. Whatever capital they might have at their disposal, usually it is not the money that they can use freely. Most arbitrageurs operate in the role of an agent managing other people’s money, and thus are limited by constraints imposed by the capital’s real owners.

The Importance of Eliminating Informational Inefficiencies

Although markets are known to be broadly efficient, pockets of informational inefficiencies obviously appear from time to time. Eliminating those inefficiencies is not only in the interest of investors and public companies, but also in the interest of governments and general public. That interest is best demonstrated through the effect efficient markets have on the overall economic growth and industry development.

Simply, if the markets are not properly priced, allocation of resources is going to be imbalanced. For example, companies that require capital to grow may not be able to obtain that capital because it may cost too much and thus not justify going ahead with certain vital projects. In contrast, if a company’s stock is overvalued, investors are likely to put excess buying pressures on it, allocating more capital to the company than it is worth.

Obviously, to maintain the appropriate level of economic growth and maximize social benefit, it is of paramount importance to achieve the highest degree possible of market efficiency.

(This article is part of a series. Access the next article in the series by following this link.)

Sources:

• Beyond the Random Walk: A Guide to Stock Market Anomalies and Low Risk Investing, by Vijay Singal, 2004;
• Investment Analysis and Portfolio Management, Eighth Edition, by Frank K. Reilly and Keith C. Brown, 2005;