What is market inefficiency?

An inefficient market is a market where an asset’s price does not reflect its actual value accurately. This occurs for several reasons. In the actual market, many markets display these inefficiencies. If displayed and used a lot, these market inefficiencies might lead to market failure.

All of the publicly available information about a stock (asset) should be completely reflected in its market price. But, in an inefficient market, the publicly available information is not truly reflected in the market price. This opens the market to bargains or suggests that the stock is over-priced

Market inefficiencies usually exist due to market psychology, transaction fees/costs, information asymmetries (transactions where one party has superior information to the other), and human emotion. This leads to the assets being over-priced or under-priced. This gives the occasion for producing excess profits. Let’s understand how investors attempt to profit from market inefficiencies.

The existence of inefficient markets challenges the EMH- efficient market hypothesis (an economic hypothesis that states that an asset’s value should be reflected in its price). An inefficient market does not comply with this hypothesis.

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Efficient Market Hypothesis

The efficient market hypothesis is mainly of three types-

  • Weak- The weak form postulates that an efficient market should reflect all the previously available public information- which includes past returns.
  • Semi-strong – The semi-strong form postulates that an efficient market should reflect previously and also currently available information.
  • Strong- The strong form postulates that an efficient market reflects currently and previously available public information along with the information that is not publicly available.

EMH adherents believe that outperforming the market becomes a difficult task due to the market’s high degree of efficiency, whereas, EMH cynics have reason to believe that investors with insight possess the potential to outperform the market through strong strategies.

Consequently, we can say that some investors stand to gain huge returns due to inefficient markets owing to the level of their risk exposure. If at all market inefficiencies didn’t exist, these occasions would not exist as an asset’s price would acutely reflect its true value. This is how investors attempt to profit from market inefficiencies.

We can state that when a specific security price does not reflect its value, it is an indicator of an inefficient market. Let’s understand this with the help of an example. Let’s suppose that newly available public information about a particular asset has somehow emerged, an efficient market would be quick enough to distribute this piece of information to all the necessary parties whereas, an inefficient market would have a lot of delays in between.

On the contrary, an investor’s lack of judgment can open up paths to tremendous losses. In this type of market, the arbitrageurs (in simple words, brokers) and speculators are the most important parties in the market. Such parties can only profit in a behavioral finance market (a market that adheres to psychologies or theories to predict the outcomes of the market happenings).

In an efficient market, no strategy can help people to outperform the market. The inefficient market is just and tends to comply with all the available information.

This gives the investors a certain advantage because no information about the stock has been held back from them. The investors are exposed to a certain level of the risk factor which drives up their profit. They stand to gain profits due to this. Consequently, we can conclude that the added risk is how investors attempt to profit from market inefficiencies. Thus inefficient markets can prove to be very beneficial to investors. This leads to the investors preferring the inefficient market and its demand.