An efficient market (informationally efficient market) is a market in which asset prices reflect new information both quickly and rationally, for all past and present information. In highly efficient markets, passive investment strategies (those that do not seek risk adjusted returns) are preferred to active investment strategies because of lower costs. Contrarily in inefficient markets, opportunities may exist for an active investment strategy to achieve superior risk-adjusted returns. In efficient markets, prices should be expected to react only to information that is not anticipated fully by investors (“surprises”).
Market value is the price at which an asset can currently be bought or sold. Intrinsic value (fundamental value) is the value that would be placed by investors if they had a complete understanding of the asset’s investment characteristic, usually by the present value of all expected future cash flows of the asset. If investors believe a market is highly efficient, they would assume prices accurately reflect intrinsic values. Discrepancies between market and intrinsic value are the basis for profitable “active” investments; for instance, active investors seek to own assets below intrinsic value (buy low meaning market is undervalued) and sell assets above intrinsic value (sell high meaning market is overvalued). Additionally, the market value represents the intersection of supply and demand. Do note, that relevant information about valuations flow continually to investors, therefore if intrinsic values changes, that may change market values.
Transactions and Information-acquisition costs affect the interpretation of market efficiency. In terms of transaction costs, “efficient” should be viewed as “efficient” within the boundaries of transaction costs. For instance, if a price discrepancy between two markets is smaller than the transaction costs, arbitrage will not occur due the higher cost of executing the trade (making it “efficient”). In terms of information-acquisition costs, the modern perspective views a market inefficient if after deducting the cost, active investing can earn superior returns. A price discrepancy must be “sufficiently” larger to leave investors profit after adjusting for transaction and information-acquisition costs, to conclude that a market may be inefficient. Active trading in semi-strong-form efficient markets cannot beat the markets on a consistent basis; therefore, passive portfolio management should outperform active portfolio management. Good portfolio managers are not necessarily measured on how they beat the market, but rather establish a portfolio consistent within their portfolio’s objectives (with proper diversification and asset allocation).
Eugene Fama defines three forms of efficiency (Efficient Market Hypothesis) being (i) weak, (ii) semi-strong, and (iii) and strong. Key note to remember is that consistently earning abnormal returns (actual return – expected return) is evidence contrary to efficient markets.
Weak-form efficient market hypothesis states that security prices fully reflect all past market data, which refers to all historical pricing and trading volume information. Tests of whether securities markets are weak-form efficient require looking at patterns of prices. Overall, evidence indicates that technical analysts cannot consistently earn abnormal profits using past prices, effectively supporting market efficiency.
Semi-strong-form efficient market states that prices reflect all publicly known and available information. Publicly available information includes financial statement data and market data. Moreover, if a market is semi-strong efficient, then it is also weak-form efficient. In this market, share prices react quickly and accurately to public information. For example, excess returns at the time of earnings announcements does not necessarily mean market inefficiency, but rather a trading opportunity where trading occurs on a basis of the announcement; which would not, on average, yield consistent abnormal returns (making it efficient).
Strong-form efficient market states that security prices fully reflect both public and private information and by definition, is also a semi-strong and weak-form efficient market. By nature of knowing non-public private information, prices should reflect everything, where hypothetically, inside traders cannot earn abnormal returns (securities laws prevent exploitation of non-public information, not rendering markets strong-form efficient).
A market anomaly occurs if a change in the price of an asset cannot directly be linked to current relevant information known or to the release of new information. In the search for discovering anomalies, many possible “findings” could just be a product of data mining (aka data snooping). Although identified anomalies may frequently appear to produce excess returns, it is difficult to exploit excess risk-adjusted returns after accounting for risk, trading costs, and other factors. Most researchers conclude that observed anomalies are not violations of market efficiency but rather a result of statistical methodologies (i.e. data snooping) to detect anomalies.