Informationally Efficient Market

The informationally efficient market theory moves beyond the definition of the well-known efficient market hypothesis. Eugene F. Fama, the 2013 Nobel Prize winner, defined a market to be “informationally efficient” if prices always incorporate all available information. In this scenario, all new information about any given firm is certain and immediately priced into that company's stock.

In practice, prior to a large and/or relevant news release, a company's stock usually changes in market value, due to investors and traders’ research and speculation. In an informationally efficient market, however, following the news release, there would be little to no price change.

Informational efficiency is a natural consequence of competition, few barriers to entry, and low costs of obtaining and publishing information, according to Fama’s “Efficient Capital Markets: a Review of Theory and Empirical Work.”

An informationally efficient market means something different than a market that simply operates effectively. For example, just because market regulators place and fill orders in a timely manner does not mean that asset prices are fully up-to-date.

Fama's and other economists' work on informationally efficient markets has led to the rise of passive index funds. So far, 2018 has continued to see outflows from many active managers that are not outperforming the markets into passive funds, such as Fidelity and Vanguard.

The Efficient Market Hypothesis (EMH) states that it is impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. According to the theory, stocks always trade at their fair value on stock exchanges, making it useless to try to outperform the market via expert stock selection or market timing.

The efficient market hypothesis incorporates weak, semi-strong, and strong levels:

Weak-form EMH implies that price movements and volume data do not affect stock prices. Fundamental analysis can be used to identify undervalued and overvalued stocks, and investors can earn profits by gaining insight from financial statements, but technical analysis is invalid.

Semi-strong EMH implies that the market reflects all publicly available information. Stocks quickly absorb new information, such as quarterly or annual earnings reports; therefore, fundamental analysis is invalid. Only information that is not readily available to the public can help investors outperform the market.

Strong-form EMH implies that the market is efficient. It reflects all information, both public and private. No investor is able to profit above the average investor even if she receives new information.