Question

What makes a capital market efficient? What is the value to the US investor of investing in a capital market that is not efficient?

Answer 1

Market efficiency refers to the degree to which market prices reflect all available, relevant information. If markets are efficient, then all information is already incorporated into prices, and so there is no way to "beat" the market because there are no undervalued or overvalued securities available. As the quality and amount of information increases, the market becomes more efficient reducing opportunities for arbitrage and above market returns. If there are sufficient checkpoints available in a capital market such that all the material information about a company is available to everyone at the same time, it would make capital market efficient. For example, company have conference calls with the funds managers about company's future strategy and the calls are publicly available. Hence, even a small investor like me has same kind of information what a big-shot high profile fund manager has.

Value to the US investor of investing in a capital market that is not efficient- If the market is efficient, it is impossible to beat the market. In that case, individual investor can simply invest in the market indices like S&P 500 index. There is no need to individually analyse each stock as everything is correctly priced.

However, if market is inefficient, small investors can invest in the mutual funds which have consistently beaten the market as now there is information asymmetry and it is indeed possible to beat the market. The investor can also do individual stock analysis and invest in underpriced securities.