Market efficiency describes the degree to which relevant information is integrated into the price of a security. With the prevalence of information technology today, markets are considered highly efficient; most investors have access to the same information with prices and industry news, updated instantaneously. The Efficient Market Hypothesis stems from this idea.
Efficient markets are said to have all relevant information priced-in to the securities almost immediately. High trading volume also makes a market more efficient, as there is a high degree of liquidity for buyers and sellers, and the spread between bid and ask prices narrows.
When a security has arrived at a price that buyers and sellers agree upon, it is said to have reached a point of equilibrium. This is the most efficient way for a market to function. Electronic networks pair buyers and sellers around the world as quickly as possible. Market Makers on stock exchanges play the role of providing liquidity in the event that it is lacking.
The Efficient Market Hypothesis is the idea that it is impossible to beat the market, because prices will swing up and down until they reach equilibrium, but there will be an equal chance of winning and losing on bets that seek to exploit the swings. In the long run, according to the theory, a low-fee index fund will be the most profitable strategy.
Many investors today adhere to this philosophy, even if they don’t probe too deeply into its theory, because it makes sense to people, and long-term average returns on low-cost index funds have outpaced actively managed funds that charge fees and attempt to generate alpha (beat the market average).
Many active strategies have outdone the indexes for certain periods of time, but not many of them have persistently done so over long stretches. The task of picking a winner is a difficult one, and many investors have decided to take what seems like a safer bet and just ride the index in passive funds.
What does the Efficiency Ratio Mean?
Are the Markets Efficient?