Understanding Inefficient Markets: Causes & Implications

An indicator of an inefficient market is when a specific security price at any particular time does not reflect its true value. This market functions differently from the efficient markets hypothesis. For example, when new information from a recent event occurs, an efficient market would quickly disperse this information to all relevant parties, whereas an inefficient market would have gaps and delays.

On the opposite end, poor judgment can lead to immense losses. Usually, speculatorsSpeculatorA speculator is an individual or firm that, as the name suggests, speculates – or guesses – that the price of securities will go up or down and trades the securities based on their speculation. Speculators are also people who create fortunes and start, fund, or help to grow businesses. and arbitrageurs are the prominent players in this market. In non-behavioral finance, they don’t stand a chance to profit from the market. It is because all the information is perceived to be reflected by the current price.

Summary

• An inefficient market is a market whose security price at any particular time does not entirely reflect the value of its assets.
• Traders can beat the market because they can employ strategies like arbitrage and speculation.
• According to the efficient market hypothesis (EMH), in a perfect market, the security prices reflect the true and fair value of all the underlying securities’ assets at any particular time.

Understanding Inefficient Markets

An inefficient market does not conform to the laws of the efficient market hypothesis (EMH)Efficient Markets HypothesisThe Efficient Markets Hypothesis is an investment theory primarily derived from concepts attributed to Eugene Fama's research work., which states that, in a perfect market, the securities prices reflect the true and fair value of all the underlying securities’ assets. Purportedly, if all the investors were to invest in equal shares, none will gain more returns from their investments since all the information of the security is readily available to all market players.

Ideally, in an inefficient market, no strategy employed will outrun the market. The market is fair and conforms to the available information. Speculators and arbitrageurs, therefore, cannot stand a chance in the ideal situation of this market. Proponents of this idea advise investors to invest in passively managed securities like exchange-traded funds (ETFs), bonds, and mutual fundsMutual FundsA mutual fund is a pool of money collected from many investors for the purpose of investing in stocks, bonds, or other securities. Mutual funds are owned by a group of investors and managed by professionals. Learn about the various types of fund, how they work, and benefits and tradeoffs of investing in them, which do not attempt to beat the market.

Causes of Inefficient Markets

1. Absence of information

If information about a specific security, which influences the price, is not readily available, price determination and prediction may be impossible. It is, therefore, futile to determine the actual value of such a financial asset at that particular timeframe.

2. Delayed reaction to the news

More often than not, major news releases influence prices of affected stocks positively or negatively. However, in an inefficient market, the asset prices do not entirely react immediately to the news.

A noticeable delay may be experienced. That little window creates an opportunity for the minor players to make a profit. Huge losses can also accrue.

Market Anomalies and Behavioral Finance

In his book “Misbehaving,” the 2017 Nobel Prize winner and champion of behavioral economics, Professor Richard H. Thaler, suggests that humans are prone to error; they are occasionally irrational. And even worse, they are behavioral biased. Therefore, a market cannot always be efficient.

Anomalies like bubbles triggered by certain events such as news often happen in the market. Thaler posed the argument to Noble laureate Eugen F. Fama on June 30, 2016 on a show hosted by Chicago Booth Review. In his skepticism of EMH, Thaler illustrates the U.S. government’s announcement on relaxing several restrictions against Cuba in late 2014 caused a price shoot of the mutual funds under the ticker CUBA.

The mutual fund’s market price was inflated by 70% – the paradox being, what if the security’s assets did not show any sign of improved performance. The occurrence was, arguably, an irrational response to the news. Regardless, the noticeable bubble lasted for nearly a year before returning close to the previous momentum.

Clearly, the example above illustrates the shortcomings of the efficient market model. Economists unanimously agree it is not possible to develop a perfect hypothesis test for it. Upheavals in the market – like price fluctuations due to lack of consumer confidence or bad or good news – can lead to an anomaly. The model, therefore, is a half-truth of the security market.

Arbitrage and Speculation in Inefficient Markets

While most of the stock market fairly reflects tendencies of efficiency depending on the type of security traded and events occurring in the market, that is not always the case. Price does not always reflect the accurate value of the stock. For example, a news release with a positive outcome – such as a breakthrough in a vaccine product – may not have an immediate reaction in the market.

For example, if a unique group of traders has insider informationInsider InformationInsider information, also called inside information, refers to non-public facts regarding a publicly traded company that can provide a financial advantage in the markets. In other words, insider information is knowledge and information on the operations, products/services pipeline, they could buy the share at ridiculously underpriced prices with the goal of capitalizing on the speculated security price movements. This is a common practice in day trading.

Traders regularly arbitrage or speculate on prices. They withhold stocks for a short while, as little as under a minute or a day, only to sell them later for a desirable price. These incidents are some of the criticisms raised against the EMH. Beating the market is against the EMH’s assumptions since such opportunities or threats cannot exist for a noticeable timeframe.

Related Readings

CFI offers the Capital Markets & Securities Analyst (CMSA)®Program Page - CMSAEnroll in CFI's CMSA® program and become a certified Capital Markets &Securities Analyst. Advance your career with our certification programs and courses. certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:

• Arbitrage Pricing TheoryArbitrage Pricing TheoryThe Arbitrage Pricing Theory (APT) is a theory of asset pricing that holds that an asset’s returns can be forecasted with the linear relationship of an
• Day TradingDay TradingThe main attribute of day trading is that the purchasing and selling of securities occurs within the same trading day.
• Exchange-Traded Fund (ETF)Exchange Traded Fund (ETF)An Exchange Traded Fund (ETF) is a popular investment vehicle where portfolios can be more flexible and diversified across a broad range of all the available asset classes. Learn about various types of ETFs by reading this guide.
• Fair ValueFair ValueFair value refers to the actual value of an asset - a product, stock, or security - that is agreed upon by both the seller and the buyer. Fair value is applicable to a product that is sold or traded in the market where it belongs or under normal conditions - and not to one that is being liquidated.