Price Efficiency

What Is Price Efficiency?

Price efficiency is an investment theory claiming that asset prices reflect the possession of all available information by all market participants.

Understanding Price Efficiency

Price efficiency theory posits that markets are efficient because all relevant information that impacts valuations is in the public domain. That means it should be nearly impossible for investors to earn excess returns or “alpha” on a consistent basis.

The efficient market hypothesis (EMH) asserts that the market rationally digests all information that is available and prices it into the valuation of assets immediately. Price efficiency is a shared article of faith for the adherents of all of the three versions of EMH. Each version of this theory assumes that prices — and markets — are efficient.

1. Proponents of the “weak” form of EMH claim that the current prices of publicly-traded securities reflect all available information about them, so their past prices offer no guidance for predicting future price trends.
2. The “semi-strong” version of EMH argues that while prices are efficient, they react instantaneously to new information.
3. Finally, adherents of the “strong” version of EMH maintain that asset prices reflect not just public knowledge, but private insider information as well.

Example of Price Efficiency

Fictional company CDE currently trades at $20 a share. One day, as expected, it releases its latest earnings report, accessible online to everyone. Performance is good, guidance is upgraded, smashing consensus estimates, and CDE also adds that it is close to making a big acquisition that offers many synergies and should double profits.

News that CDE plans to use some of its excess capital to chase an exciting new growth opportunity will presumably lead the share price to rise, as will a brighter trading outlook. Everyone received this information, and all are expected to agree that the company is now worth more, resulting in price efficiency.

If this big update was somehow only available to a select few people. there would be less price efficiency. Those unaware will see no reason why the shares should trade at more than $20 as, to their knowledge, nothing has changed. Those in the know will likely have other ideas, pushing up CDE’s valuation. Suddenly, the price of CDE isn’t reflective of all the information available in the public domain.

Limitations of Price Efficiency

EMH is a cornerstone of modern financial theory but still attracts plenty of scrutiny. Critics point out that price efficiency makes a lot of assumptions that do not always play out in reality.

Not everyone will have the same idea of how much an asset should be worth, even if they are all privy to the same information. Perception can differ. For example, some investors may be really bullish about CDE’s acquisition strategy, while others may question the logic and see pitfalls. Likewise, some investors may value companies that hoard cash over ones that seek to put their money to work, believing that this bodes better for dividend payments.

Different thinking leads to potential pricing anomalies, undermining the notion posited by EMH that it is impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices.

Another example that questions the idea that stock prices do not drastically deviate from their fair values is major stock market crashes. These crashes are often based on general sentiment, rather than a specific shift in a company’s fundamentals.