Informationally Efficient Market

What Is an Informationally Efficient Market?

In 1970, Eugene F. Fama, the 2013 Nobel Prize winner, defined a market to be “informationally efficient” if prices always incorporate all available information. In this scenario, all new information about any given firm is certain and immediately priced into that company's stock. The informationally efficient market theory moves beyond the definition of the well-known efficient market hypothesis, previously developed by Fama.

Understanding Informationally Efficient Market

In practice, prior to a large and/or relevant news release, a company's stock usually changes in market value, due to investors and traders’ research and speculation. In an informationally efficient market, however, following the news release, there would be little to no price change. In effect, the market is already said to have incorporated the effects of fresh information, such as press releases, into a stock's price.

Informational efficiency is a natural consequence of competition, few barriers to entry, and low costs of obtaining and publishing information, according to Fama’s “Efficient Capital Markets: a Review of Theory and Empirical Work.”

An informationally efficient market means something different from a market that simply operates effectively. Just because market regulators place and fill orders in a timely manner, for example, does not mean that asset prices are fully up-to-date. Similarly, technical trading rules formulated by statisticians and fundamental analysis conducted by star analysts do not mean a thing in informationally efficient markets.

Fama's and other economists' work on informationally efficient markets has led to the rise of passive index funds.

In recent times, passive funds, such as Fidelity and Vanguard, have witnessed a large inflow of funds from active managers, who are struggling to generate returns for their investors. Most major hedge funds have witnessed a decline in their returns even as Warren Buffett has counseled investors and traders to put their money into passive funds.

Informationally Efficient Market and the Efficient Market Hypothesis

The efficient market hypothesis (EMH) states that it is impossible for investors to purchase undervalued stocks or sell stocks for inflated prices. According to the theory, stocks always trade at their fair value on stock exchanges, making it useless to try to outperform the market via expert stock selection or market timing.

The efficient market hypothesis incorporates weak, semi-strong, and strong levels:

Weak-form EMH implies that price movements and volume data do not affect stock prices. Fundamental analysis can be used to identify undervalued and overvalued stocks, and investors can earn profits by gaining insight from financial statements, but technical analysis is invalid.

Semi-strong-form EMH implies that the market reflects all publicly available information. Stocks quickly absorb new information, such as quarterly or annual earnings reports; therefore, fundamental analysis is invalid. Only information that is not readily available to the public can help investors outperform the market.

Strong-form EMH implies that the market is efficient. It reflects all information, both public and private. No investor is able to profit above the average investor even if they receive new information.

Criticism of Informationally Efficient Markets

In a 1980 paper, Sanford Grossman and Joseph E. Stiglitz posited that competitive markets exist in a state of disequilibrium. "... prices reflect the information of informed individuals (arbitrageurs) but only partially, so that those who expend resources to obtain information do receive compensation," they wrote. "How informative the price system is depends on the number of individuals who are informed."

This means that if market participants pay attention to news and expend time, effort, and money on research and analysis, then markets may be informationally efficient, though there is some cost associated with making them so. However, it also implies that one of the major takeaways from the EMH and the concept of informationally efficient markets is flawed; namely, that when more investors choose passive investment vehicles and neglect to obtain their own information to make investment decisions, then they can make the market less informationally efficient. The fewer individuals who stay informed on matters that drive prices, the less informationally efficient the market will be.