Financial market efficiency

In the 1970s Eugene Fama defined an efficient financial market as "one in which prices always fully reflect available information".^[3]

Fama identified three levels of market efficiency:

1. Weak-form efficiency

Prices of the securities instantly and fully reflect all information of the past prices. This means future price movements cannot be predicted by using past prices, i.e past data on stock prices is of no use in predicting future stock price changes.

2. Semi-strong efficiency

Asset prices fully reflect all of the publicly available information. Therefore, only investors with additional inside information could have an advantage in the market. Any price anomalies are quickly found out and the stock market adjusts.

3. Strong-form efficiency

Asset prices fully reflect all of the public and inside information available. Therefore, no one can have an advantage in the market in predicting prices since there is no data that would provide any additional value to the investors.

Price Changes Reflect^[4]

Forms	Past Market Data	Public Information	Private Information
Weak	Yes	No	No
Semi-strong	Yes	Yes	No
Strong	Yes	Yes	Yes

Fama also created the efficient-market hypothesis (EMH), which states that in any given time, the prices on the market already reflect all known information, and also change fast to reflect new information.

Therefore, no one could outperform the market by using the same information that is already available to all investors, except through luck.^[5]

Another theory related to the efficient market hypothesis created by Louis Bachelier is the "random walk" theory, which states that prices in the financial markets evolve randomly.

Therefore, identifying trends or patterns of price changes in a market can't be used to predict the future value of financial instruments.

• Predicting future asset prices is not always accurate (represents weak efficiency form)
• Asset prices always reflect all new available information quickly (represents semi-strong efficiency form)
• Investors can't outperform on the market often (represents strong efficiency form)

• There is a vast literature in academic finance dealing with the momentum effect that was identified by Jegadeesh and Titman.^[6][7] Stocks that have performed relatively well (poorly) over the past 3 to 12 months continue to do well (poorly) over the next 3 to 12 months. The momentum strategy is long recent winners and shorts recent losers, and produces positive risk-adjusted average returns. Being simply based on past stock returns that are functions of past prices (dividends can be ignored), the momentum effect produces strong evidence against weak-form market efficiency, and has been observed in the stock returns of most countries, in industry returns, and in national equity market indices. Moreover, Fama has accepted that momentum is the premier anomaly.^[8][9]
• January effect (repeating and predictable price movements and patterns occur on the market)
• Stock market crashes, Asset Bubbles, and Credit Bubbles
• Investors that often outperform on the market such as Warren Buffett,^[10] institutional investors, and corporations trading in their own stock
• Certain consumer credit market prices don't adjust to legal changes that affect future losses

Financial market efficiency is an important topic in the world of finance. While most financiers believe the markets are neither efficient in the absolute sense, nor extremely inefficient, many disagree where on the efficiency line the world's markets fall.

• Pilbeam, Keith (2005). Finance and Financial Markets. Palgrave Macmillan. ISBN 978-1-4039-4835-9.
• Mishkin, Frederic (1998). The economics of money, banking, and financial markets. Addison Wesley. ISBN 978-0-321-01440-5.
• Hasan, Iftekhar; Hunter, William C. (2004). Bank and financial market efficiency. Emerald Group. ISBN 978-0-7623-1099-9.
• Richard, Mark; Vecer, Jan (1 February 2021). "Efficiency Testing of Prediction Markets: Martingale Approach, Likelihood Ratio and Bayes Factor Analysis". Risks. 9 (2): 31. doi:10.3390/risks9020031. hdl:10419/258120.
• Davidson, Paul. Financial markets, money and the real world. Edward Elgar Publishing, 2002.
• Emilio Colombo, Luca Matteo Stanca. Financial Market Imperfections and Corporate Decisions. Springer, 2006.
• Frisch, Ragnar Anton Kittel. Econometrica. Econometric Society, JSTOR, 1943.
• Leffler, George Leland. The Stock Market. 2. Ronald Press Co., 1951.
• Marc, Levinson. Guide to Financial Markets. 3. Bloomberg Press, 2003.
• Peters, Edgar E. Fractal Market Analysis: Applying Chaos Theory to Investment and Economics. John Wiley and Sons, 1994.
• Teall, John L. Financial market analytics. Greenwood Publishing Group, 1999.