What Is an Inefficient Market? Definition, Effects, and Example (2024)

What Is an Inefficient Market?

According to economic theory, an inefficient market is one in which an asset's prices do not accurately reflect its true value, which may occur for several reasons. Inefficiencies often lead to deadweight losses. In reality, most markets do display some level of inefficiencies, and in the extreme case an inefficient market can be an example of a market failure.

The efficient market hypothesis (EMH) holds that in an efficiently working market, asset prices always accurately reflect the asset's true value. For example, all publicly available information about a stock should be fully reflected in its current market price. With an inefficient market, in contrast, all the publicly available information is not reflected in the price, suggesting that bargains are available or that prices could be over-valued.

Key Takeaways

  • An inefficient market is one that does not succeed in incorporating all available information into a true reflection of an asset's fair price.
  • Market inefficiencies exist due to information asymmetries, transaction costs, market psychology, and human emotion, among other reasons.
  • As a result, some assets may be over- or under-valued in the market, creating opportunities for excess profits.
  • The presence of inefficient markets in the world somewhat undermines economic theory, and in particular the efficient market hypothesis (EMH).

Understanding Inefficient Markets

Before looking at inefficient markets, we must first lay out what economic theory proposes an efficient market must look like. The efficient markets hypothesis (EMH) takes on three forms:

  1. Weak form asserts that an efficient market reflects all historical publicly available information about the stock, including past returns.
  2. Semi-strong form purports that an efficient market reflects historical as well as current publicly available information.
  3. Strong form holds that an efficient market reflects all current and historical publicly available information as well as non-public information.

Proponents of the EMH believe that the market's high degree of efficiency makes outperforming the market difficult. Most investors would, therefore, be well-advised to invest in passively managed vehicles such as index funds and exchange-traded funds (ETF), which don't attempt to beat the market. EMH skeptics, on the other hand, believe that savvy investors can outperform the market and, therefore, actively managed strategies are the best option.

Thus, in an inefficient market, some investors can make excess returns while others can lose more than expected, given their level of risk exposure. If the market were entirely efficient, these opportunities and threats would not exist for any reasonable length of time since market prices would quickly move to match a security's true value as it changed. Quantitative analysts will look to the concept of entrophy, or randomness, to predict the probable price movement direction or the repetition of a pattern.

The EMH has several problems in reality. First, the hypothesis assumes all investors perceive all available information in precisely the same manner. The different methods for analyzing and valuing stocks pose some problems for the validity of the EMH. If one investor looks for undervalued market opportunities while another evaluates a stock on the basis of its growth potential, these two investors will already have arrived at a different assessment of the stock'sfair market value. Therefore, one argument against the EMH points out thatsince investors value stocks differently, it is impossible to determine what a stock should be worth in an efficient market.

While many financial markets appear reasonably efficient, events such as market-wide crashes and the dotcom bubble of the late '90s seem to reveal some sort of market inefficiency.

Example: Active Portfolio Management

If markets are truly efficient, then there is no hope to beat the market as an investor or trader. The EMH states that no single investor is ever able to attain greater profitability than another with the same amount of invested funds under the efficient market hypothesis. Since they both have the same information, they can only achieve identical returns. But consider the wide range of investment returns attained by the entire universe of investors,investment funds, and so forth. If no investor had any clear advantage over another, would there be a range of yearly returns in the mutual fund industry, from significant losses to 50% profits or more? According to the EMH, if one investor is profitable, it means every investor is profitable. But this is far from true.

Regarding passively managed versus actively-managed vehicles, the inefficiency of markets reveals itself. For example, large-cap stocks are widely held and closely followed. New information about these stocks is immediately reflected in the price. News of a product recall by General Motors, for example, is likely to immediately result in a drop in GM's stock price. In other parts of the market, however, particularly small caps, some companies may not be as widely held and closely followed. News, whether good or bad, may not hit the stock price for hours, days, or longer. This inefficiency makes it more likely that an investor will be able to purchase a small-cap stock at a bargain price before the rest of the market become aware of and digests the new information.

Likewise, technical analysisis a style of trading that is completely predicated on the concept of using past data to anticipate future price movements. Technical analysis uses patterns in market data from the past to identify trends and make predictions for the future. As a result, EMH is conceptually opposed to technical analysis. Proponents of EMH are also of the belief that it's pointless to search for undervalued stocks or predict trends in the market through fundamental analysis.

What Is an Inefficient Market? Definition, Effects, and Example (2024)

FAQs

What Is an Inefficient Market? Definition, Effects, and Example? ›

An inefficient market is where the prices of assets or securities don't always reflect their actual or real value. This creates opportunities where you can buy something for less than it's actually worth or sell it for more than it's worth because not everyone has the same information at the same time.

What is an example of an inefficient market? ›

There are many real-world market inefficiency examples. Some of these are Microsoft (Windows), Apple Inc. (IOS), and utility firms among others. All these entities provide products with no direct substitutes, which gives them a great deal of control in the market.

What is the meaning of inefficient market? ›

a situation in which a financial market does not operate as well as it should, for example where customers do not have enough information about products, prices are not related to supply and demand, etc.: One reason for market inefficiency is shareholder opportunism.

What is an example of market efficiency? ›

An example of this is a stock market. If a company releases a positive financial report, in an efficient market, the price of that company's stock would instantly rise to reflect this new information. Similarly, should there be any negative news, the stock price would instantly fall to reflect the new reality.

What is the effect of an efficient market? ›

The Effect of Efficiency: Non-Predictability

According to the EMH, as prices respond only to information available in the market, and because all market participants are privy to the same information, no one will have the ability to out-profit anyone else.

How does inefficiency in markets affect consumers? ›

Inefficiency in a Monopoly

The deadweight loss is the potential gains that did not go to the producer or the consumer. As a result of the deadweight loss, the combined surplus (wealth) of the monopoly and the consumers is less than that obtained by consumers in a competitive market.

How do you identify market inefficiencies? ›

To identify market inefficiencies, you need to compare the actual market outcome with the theoretical or ideal outcome under perfect competition or Pareto efficiency.

What are the disadvantages of inefficient market? ›

Disadvantages
  • Market participants may tend to lose money very quickly and easily.
  • There is always a probability that asset bubbles and speculative-based bubbles may harbor or are around the corner in inefficient markets in inefficient markets.
Apr 4, 2024

What is the short meaning of inefficient? ›

adjective. unable to perform a task or function to the best advantage; wasteful or incompetent. unable to produce the desired result.

What is the weak form of inefficient market? ›

The weak form of EMH is the lowest form of efficiency that defines a market as being efficient if current prices fully reflect all information contained in past prices. This form implies that past prices cannot be used as a predictive tool for future stock price movements.

What is market efficiency in simple words? ›

Market efficiency refers to the ability possessed by markets to include information that offers maximum possible opportunities for traders to buy and sell securities without incurring additional transaction costs. The concept of market efficiency is closely linked to the efficient market hypothesis (EMH).

What are the three 3 forms of market efficiency? ›

Fama identified three levels of market efficiency:
  • Weak-form efficiency.
  • Semi-strong efficiency.
  • Strong-form efficiency.

What are the 3 keys to market efficiency? ›

In the realm of finance, market efficiency refers to the degree to which prices of financial assets reflect all available information. There are three main forms of market efficiency: weak form, semi-strong form, and strong form. Each form represents a different level of information incorporation into asset prices.

What is the difference between efficient and inefficient markets? ›

This market functions differently from the efficient markets hypothesis. For example, when new information from a recent event occurs, an efficient market would quickly disperse this information to all relevant parties, whereas an inefficient market would have gaps and delays.

What is the highest level of market efficiency? ›

What Is Strong Form Efficiency? Strong form efficiency is the most stringent version of the efficient market hypothesis (EMH) investment theory, stating that all information in a market, whether public or private, is accounted for in a stock's price.

Which markets are less efficient? ›

Collectible markets are often considered less efficient than traditional financial markets like stocks and bonds. Factors such as limited liquidity, information asymmetry, and the subjective nature of valuing collectibles can contribute to inefficiency.

What type of market is least efficient? ›

A monopoly is the least efficient market structure because it charges higher prices and produces lower output compared to answer types of market structures.

Which market structure is inefficient? ›

Key Takeaways

Some modern economists argue that a monopoly is by definition an inefficient way to distribute goods and services. This theory suggests that it obstructs the equilibrium between producer and consumer, leading to shortages and high prices.

References

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