In the 1970s Eugene Fama defined an efficient financial market as “one in which prices always fully reflect available information”.
The most common type of efficiency referred to in financial markets is the allocative efficiency, or the efficiency of allocating resources.
This includes producing the right goods for the right people at the right price.
A trait of allocatively efficient financial market is that it channels funds from the ultimate lenders to the ultimate borrowers in a way that the funds are used in the most socially useful manner.
Market efficiency levels
Eugene Fama identified three levels of market efficiency:
1. Weak-form efficiency
Prices of the securities instantly and fully reflect all information of the past prices. This means future price movements cannot be predicted by using past prices.
2. Semi-strong efficiency
Asset prices fully reflect all of the publicly available information. Therefore, only investors with additional inside information could have advantage on the market.
3. Strong-form efficiency
Asset prices fully reflect all of the public and inside information available. Therefore, no one can have advantage on the market in predicting prices since there is no data that would provide any additional value to the investors.
Efficient Market Hypothesis (EMH)
Fama also created the Efficient Market Hypothesis (EMH) theory, which states that in any given time, the prices on the market already reflect all known information, and
also change fast to reflect new information.
Therefore, no one could outperform the market by using the same information that is already available to all investors, except through luck.
Random Walk theory
Another theory related to the efficient market hypothesis created by Louis Bachelier is the “random walk” theory, which states that the prices in the financial markets evolve randomly and are not connected, they are independent of each other.
Therefore, identifying trends or patterns of price changes in a market couldn’t be used to predict the future value of financial instruments.