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What Is an Inefficient Market?

By Jerry Morrison
Updated May 16, 2024
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An inefficient market is one in which the prices of items traded do not reflect the best available information regarding their value. Some items will be overvalued, while others are undervalued. Consequently, some investors will realize greater returns than warranted while others will be liable to greater risk than planned. Such a situation can arise when relevant business information is not disclosed or the item traded has not been subject to sufficient analysis. It may also occur when investors disregard relevant information and are motivated by hype or emotional response.

The Efficient Market Hypothesis (EMH) is in direct contrast to an inefficient market. This hypothesis asserts that the values of items such as stocks will be based on the rational evaluation of the best information available. An incorrect valuation for a stock could only exist temporarily before the market eliminates the discrepancy. It follows from the EMH that returns on investments greater than the market average due to expert analysis should not be consistently possible. Higher returns would only be possible by making higher risk investments.

Widely accepted as a theoretical model, there is considerable controversy in applying the EMH to real markets. There are investors that have consistently outperformed the market average over the long term. Market crashes and stock bubbles, grossly overvalued stocks, would suggest that real world markets behave in many ways like an inefficient market.

Behavioral economics seeks to explain decisions leading to an inefficient market in terms of psychological and emotional factors. This approach attempts to account for market behavior that is contrary to the EMH and cannot be explained if the investor is assumed to make rational choices. The pace and presentation of information along with the characteristics of market participants are studied. These are seen as factors influencing the decisions of individual investors as wells as the direction of the market as a whole.

One such factor is referred to as the psychological state or sentiment of the market. Studies of long term trends give examples of market turns that are contrary to the rational choice assumption. A bandwagon effect might cause investors to join a trend contrary to their beliefs and analysis. Similarly, otherwise rational investors can be swept along in a panic sell-off, fueled by an unfounded fear of economic loss. Either of these psychological states leads to prices that do not reflect the true value of stocks and creates an inefficient market.

Withholding or falsifying company information to boost its perceived financial condition can result in an inaccurate stock valuation. Promoting the sale of a specific stock not on its worth but to increase brokerage fees also contributes to an inefficient market. Such unethical and illegal practices are factors are beyond the scope of market theory. They are, however, common and undermine an investor's objective analysis.

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