What is an Inefficient Market?

What is an Inefficient Market?

According to economic theory, an inefficient market is one in which an asset’s prices do not accurately reflect its true value, which may occur for several reasons. Inefficiencies often lead to deadweight losses. In reality, most markets do display some level of inefficiencies, and in the extreme case an inefficient market can be an example of a market failure.

The efficient market hypothesis (EMH) holds that in an efficiently working market, asset prices always accurately reflect the asset’s true value. For example, all publicly available information about a stock should be fully reflected in its current market price.

With an inefficient market, in contrast, all the publicly available information is not reflected in the price, suggesting that bargains are available or that prices could be over-valued.

An inefficient market is one that does not succeed in incorporating all available information into a true reflection of an asset’s fair price.

Market inefficiencies exist due to information asymmetries, transaction costs, market psychology, and human emotion, among other reasons.

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.

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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.

What Makes an Inefficient Market?

Like every investment and financial concept, the efficient market theory has its proponents and critics. The supporters of this model believe that outsmarting or outperforming the market can be quite risky due to the availability of high market efficiency.

They suggest that investors follow or invest in passively traded funds like mutual funds and hedge funds since these companies make use of available information to trend with the market. Simply put, theyre not aiming to outperform the market. On the other hand, skeptics of this model believe that there is a holy grail which well-versed investors can master and use to surpass the market.

Thus they suggest that active trading is better for investors than passively-managed funds. We however cannot conclude which side of the argument is wrong since weve seen situations where people cannot beat the market, as well as situations where people could outperform the market. Thus, we want to believe that both sides are quite right in their statements.

 Trading passively can work well for some markets, but fail totally for others, and same goes for active investments. For passively managed funds, they mainly stick to large cap stocks and indexes like the Dow Jones and the S&P 500. Whenever there is any news about these indexes and large cap funds, the public gets to know immediately without further delay.

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Most times, people refer to information provided by these large cap stocks as live news because they generally have an effect on the stocks prices at that point. However, for smaller stocks, news generally dont get disclosed as soon as there are information surrounding the stock or company. This makes it a good deal for active investors, as they get to bargain prices before ETFs and Hedges come in to purchase shares in these companies.

This also makes it possible for investors to lose and gain excess amounts in an inefficient market. It is simply based on their risk level though. If the market were to be efficient, the chance of excess returns and losses would be limited since the price of stocks listed on exchanges would quickly match the value of the stock with each new information.

 From hindsight, all financial markets might look efficient, however, we can see that there are some inefficiencies as reflected in the Dotcom bubble bursts in the late periods of the 1990s and the market crash in that same period.

Advantages of Inefficient Market

  • The market participants may earn some excess returns due to inefficiencies present in the market.
  • There may be delayed reactions to the news that may reflect the asset prices giving the speculators and small-time traders enough time to liquidate their positions and earn good profits.
  • Inefficient markets give rise to asset mispricing, which the arbitrageurs can use to derive risk-less profit.

Disadvantages of Inefficient Market

  • Market participants may tend to lose money very quickly and easily.
  • There is always a probability that asset bubbles and speculative-based bubbles may harbor or are around the corner in inefficient markets in inefficient markets.
  • The demand and supply of the asset tend to vary, invariably leading to a price mismatch in the assets held.
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It is assumed that the markets are efficient and operate according to the efficient market theory. Inefficient markets, the information and news concerning the assets are readily available. There are no assets whose prices are either undervalued or overvalued; all the assets are assumed to be equally priced.

 There is no such presence of speculators and arbitrageurs’ inefficient markets. It is a platform where the assets are not fairly and similarly priced.

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