Market Efficiency: Influencers

Efficient markets assimilate information that gets reflected in trades. Any new information in efficient markets is adjusted quickly. In reality most markets are neither fully efficient nor fully inefficient. They demonstrate various degrees of efficiency along a continuum between the opposing points of efficiency and inefficiency. The asset prices better reflect information more quickly and accurately in an efficient market rather than an inefficient one. The varying degrees of efficiency vary across geography, time, and different types of markets.

In this article we will look at some of the factors that impact market efficiency.

Market Participants

The number of market participants is a key factor that influences market efficiency. Let us take the example of a relatively small (small-cap) but strong player that is not watched keenly in the market. A small cap analyst who has been keeping tabs on the company’s positive and promising profits and growth recommends a ‘buy’ on this share. The analyst also capitalizes on the fact that the company is relatively lesser known and is not being observed by larger players.

The positive operating profits information takes a while to trickle into the market. In the meantime the small cap analyst has bought shares at prices that do not fully reflect the worth of the company, i.e., at lower than value prices.

Six months later the company further puts forth its results which are good this time round as well. The forgone profit opportunities as a result of mispricing are better known to more market participants this time around, and a large number of shares are sought. This drives the prices of the stocks up thus better reflecting the true value of the share.

In a well traded market with more participants who follow market movements closely market inefficiency like mispricing of a share will quickly be corrected.

Chinese markets for instance restrict trading by foreigners. This reduces the potential for trading and accentuates market inefficiencies.

Availability of Information and Financial Disclosures

The New York Stock exchange, the stock markets of London and Japan offer information on listed companies and trading activity easily. Listed companies are followed by several analysts and therefore efficiency in these markets is high. It is generally much lower in lesser developed markets as one perhaps that is in an emerging market.

The type of market can also determine its level of efficiency. Several securities trade in certain kinds of markets like OTC (over the counter), money market instruments, currencies, swaps and forward markets. The information that is made available regarding these markets vary  and this impacts the level of efficiency of markets.