Market efficiency is a popular term in wealth management / portfolio strategies. An easy way to think about the efficiency of a market is by looking at how much available information is already baked into the price of the market.
It’s a spectrum. A fully efficient market means that the price of listed companies already consider all possible information that’s out there and only new information can impact the price of that company. A market with zero efficiency means that there is plenty of information that you could learn about which still has the potential to impact the price of a company.
Let’s take an analogy:
Imagine you work for an art gallery in Paris and are at a local art auction in Mexico City. Because you are from Paris, you know the latest fads in the market — specifically, you know that Parisians are really into indigenous Mexican art and it can sell for high prices. So you’re at this local auction, and you see that the prices are really low. You purchase lots of paintings at a bargain and take them back to Paris, selling them locally at high prices. You just used unique information to make a profit and beat the existing market. This is an example of an inefficient market. There is high discrepancy of the level of information available to market participants.
Now let’s explore a different scenario: the same auction house in Mexico City has invested in a tech platform that shows the most recent transactions of Mexican indigenous art around the world. As a result, everyone participating in the local art auction can see the recent sale prices for the art in Paris. Oops! You don’t have an advantage anymore and the great bargain you thought you could find is not available. In fact, now it’s a very competitive bidding process. This is an example of an efficient market. Everyone has access to the same information and it’s baked into the price.
It’s important to understand and decide where you stand on efficient markets as it has a strong impact on how you invest. If you believe markets are perfectly efficient, then trying to beat the market is going to be a very tough act. It’s more competitive, and you need (legal) access to some information that somehow you can get earlier than everyone else in the market. You’d be better off investing in index funds. Whereas if you believe markets are not efficient, then there are plenty of opportunities that you can take to analyze specific opportunities and invest in them in the hope to beat the other market participants. Good luck with that.
My belief is that different markets lie at different parts of the spectrum and there aren’t any perfectly efficient markets — but generally markets get more efficient over time.
Follow a good asset allocation strategy and ensure you de risk yourself by doing a bit of both (index investing + individual picks). If you do take on the challenge of beating the market, then ensure you put in the right time and effort needed to do so.
