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CHAPTER 6
MARKET EFFICIENCY – DEFINITION, TESTS AND EVIDENCE
What is an efficient market? What does it imply for investment and valuation
models? Clearly, market efficiency is a concept that is controversial and attracts strong
views, pro and con, partly because of differences between individuals about what it really
means, and partly because it is a core belief that in large part determines how an investor
approaches investing. This chapter provides a simple definition of market efficiency,
considers the implications of an efficient market for investors and summarizes some of the
basic approaches that are used to test investment schemes, thereby proving or disproving
market efficiency. It also provides a summary of the voluminous research on whether
markets are efficient.
Market Efficiency and Investment Valuation
The question of whether markets are efficient, and if not, where the inefficiencies lie,
is central to investment valuation. If markets are, in fact, efficient, the market price provides
the best estimate of value, and the process of valuation becomes one of justifying the market
price. If markets are not efficient, the market price may deviate from the true value, and the
process of valuation is directed towards obtaining a reasonable estimate of this value. Those
who do valuation well, then, will then be able to make 'higher' returns than other investors,
because of their capacity to spot under and over valued firms. To make these higher returns,
though, markets have to correct their mistakes – i.e. become efficient – over time. Whether
these corrections occur over six months or five years can have a profound impact in which
valuation approach an investor chooses to use and the time horizon that is needed for it to
succeed.
There is also much that can be learnt from studies of market efficiency, which
highlight segments where the market seems to be inefficient. These 'inefficiencies' can
provide the basis for screening the universe of stocks to come up with a sub-sample that is
