Financial market efficiency

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

The most common type of efficiency referred to in financial markets is the allocative efficiency, or the efficiency of allocating resources. This includes producing the right goods for the right people at the right price.

A trait of allocatively efficient financial market is that it channels funds from the ultimate lenders to the ultimate borrowers in a way that the funds are used in the most socially useful manner.

Eugene 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. It is simply to say that, past data on stock prices are of no use in predicting future stock price changes. Everything is random. In this kind of market, should simply use a "buy-and-hold" strategy.

2. Semi-strong efficiency

Asset prices fully reflect all of the publicly available information. Therefore, only investors with additional inside information could have advantage on 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 advantage on the market in predicting prices since there is no data that would provide any additional value to the investors.

Fama also created the efficient-market hypothesis (EMH) theory, 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.

Another theory related to the efficient market hypothesis created by Louis Bachelier is the "random walk" theory, which states that the prices in the financial markets evolve randomly and are not connected, they are independent of each other.

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

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Wikipedia