Contemporary Finance

7Capital Market Efficiency

Come, fill the South Sea goblet full;

The gods shall of our stock take care;

Europa pleased accepts the Bull,

And Jove with joy puts off the Bear.

Alexander Pope, “An Inscription upon a Punch-Bowl”¹

Market efficiency is the proposition that observable asset prices are as close as possible to “correct,” in the sense of incorporating all information or reflecting the asset’s fundamental value. Efficiency implies a tendency for markets to diminish but not necessarily eliminate arbitrage opportunities. It is impossible to systematically earn “abnormal” returns—higher risk-adjusted returns than the market as a whole—without engaging in higher risk or bearing some cost. Information diffuses and influences market participants’ buy and sell decisions fast enough that riskless arbitrage profits are unusual.

In the purist market efficiency viewpoint, held by precisely no one, markets clear smoothly and continuously and asset prices reflect all available information about the determinants of fundamental value at all times. But there are more nuanced views that allow for the messiness of markets in a friction-ridden real world. Nobody’s view of the correct price is demonstrably superior to the market price. Prices act as signals even if they are not perfectly correct at any time. Information is partial, dispersed among many people, and constantly evolving. There is a tendency toward equilibrium, even if equilibrium is never actually reached as the world changes ...