What is market efficiency?

When money is placed on a financial market such as the forex, the objective is to generate a return on the capital invested. Many traders don't just try to make profits, but also to outperform and beat the market.

However, the hypothesis of market efficiency suggests that at all prices fully reflect the information available for a particular asset or market at all times. The efficient market hypothesis is that no investor has a real advantage in predicting market behaviour because no one has access to relevant information that is not available to others.

The effect of efficiency on the market: the inability to predict price action

The nature of the information should not be limited to economic indicators and financial news alone; in fact, information about politics, economics and social events, combined with how traders perceive this data, whether real or just rumour, will affect the price of the asset in the market. The efficient market hypothesis is that since prices react only to information available on the market and that all market players have access to the same information, no one has the opportunity to outperform others.

In efficient markets, prices aren't predictable, but random, which means that no investment model can be discerned. Therefore, no planned trading approach can be successful.

This "random walk" of prices, which we regularly talk about in the school of thought of the efficient market, leads to the failure of trading strategies whose logical objective is to constantly beat the market. In fact, the efficient market hypothesis suggests that given the transaction costs involved in managing an investment portfolio, it would be more profitable for an investor to invest their money in a regular index fund.

Market anomalies: the challenges of efficiency

However, in the real world of trading in financial markets, there are obvious arguments against the assumption of market efficiency. There are investors who beat the markets and who are constantly making profits. Renowned billionaire investor Warren Buffet, whose investment strategy is based on undervalued stocks, has made many billions of dollars and set the example for many. There are portfolio managers who have historically performed better than others, and there are also investment companies that have a more reputable research and analysis department than others. So how can market performance be random when there are traders who regularly outperform the market and make profits?

There is also a counter argument to the market efficiency hypothesis: there are consistent models in the markets. For example, the January effect is a theory that shows that the highest returns in the stock market tend to occur in the first month of each year; and the weekend effect is the downward trend in stock market returns on Mondays compared to stock market gains on previous Fridays.

Financial behaviour studies, which analyse the effects of trader psychology on the markets, also reveal that investors are subject to many biases, such as confirmatory bias, risk aversion and overconfidence.

Issues regarding the market efficiency hypothesis

The assumption of an efficient market doesn't exclude the possibility of market anomalies that could lead to the generation of higher revenues. In fact, market efficiency doesn't require that prices always be equal to their fair value. Prices can be over or under-valued only during random events, so that they eventually return to their average values. As such, deviations from the fair market price are themselves random events, trading strategies in which the trader tries to beat the market cannot produce consistent results over the long term.

Furthermore, this approach argues that a trader who outperforms the market doesn't do so by skill, but rather by chance. Proponents of the efficient market hypothesis argue that this is due to the laws of probability: at some point in a market with a large number of traders, some of them will perform better than others, while others will be less efficient.