The term “efficient” capital market has been used in several contexts to describe the operating characteristics of a capital market. There is a distinction, however, between an operationally (or internally) efficient market and a pricing (or externally) efficient capital market.
Pricing efficiency refers to a market where prices at all times fully reflect all available information that is relevant to the valuation of securities. That is, relevant information about the security is quickly impounded into the price of securities. In his seminal review article on pricing efficiency, Eugene Fama points out that in order to test whether a market is price efficient, two definitions are necessary. First, it is necessary to define what it means that prices “fully reflect” information. Second, the “relevant” set of information that is assumed to be “fully reflected” in prices must be defined. Fama, as well as others, defines “fully reflects” in terms of the expected return from holding a security. The expected return over some holding period is equal to expected cash distributions plus the expected price change, all divided by the initial price. The price formation process defined by Fama and others is that the expected return one period from now is a stochastic (i.e., random) variable that already takes into account the “relevant” information set.
In defining the “relevant” information set that prices should reflect, Fama classified the pricing efficiency of a market into three forms: weak, semistrong, and strong. The distinction between these forms lies in the relevant information that is hypothesized to be impounded in the price of the security. Weak efficiency means that the price of the security reflects the past price and trading history of the security. Semistrong efficiency means that the price of the security fully reflects all public information (which, of course, includes but is not limited to historical price and trading patterns). Strong-form efficiency exists in a market where the price of a security reflects all information, whether or not it is publicly available.
A price-efficient market has implications for the investment strategy that investors may wish to pursue. Throughout this blog, we shall refer to various active strategies employed by investors. In an active strategy, investors seek to capitalize on what they perceive to be the mispricing of a security or securities. In a market that is price efficient, active strategies will not consistently generate a return after taking into consideration transaction costs and the risks associated with a strategy that is greater than simply buying and holding securities. This has lead investors in certain markets that empirical evidence suggests are price efficient to pursue a strategy of indexing, which simply seeks to match the performance of some financial index.