Do markets always need to be efficient?

What is market efficiency? What is it about? How does it work? Is it possible for markets to be efficient at all time? If, yes, would it be a good thing?...

These are all the questions commonly asked in finance lectures. However, there is no “clear” answer and different theories clash. But, when looking deeper in all those theories, we can see that they are not necessarily exclusive to one another. When dealing with a subject like this one, different aspects of the problem have to be taken into account.

Literature doesn’t have a one definition for market efficiency. For Hou and Zhao (2011), the market efficiency is "the absence of arbitrage opportunity in the market". However, for this post, I’ll use a more precise definition. According to Statman (1999), market efficiency is the centre of three dimensions: standard finance, behavioural finance and investment professionals. For him, market efficiency means two things: 

• Investors cannot systematically beat the market 
• Security prices are rational

However, when according to consumers/investors behaviour studies we know that 70% of choices we make when we buy products are made by impulsion and therefore lead by sentiments, is it possible to maintain that prices are rational?

Of course not! Whether it is share prices on the stock market or goods prices in the supermarket, prices are based on demand and customer habit. Let’s take an example. Porridge. You can find some at a relatively fair price in the United Kingdome. However, in France for example, if you succeed in finding some, it would probably be much more expensive. Another example would be if a successful company had to sell a large amount of its share, for random reason, then the share price would certainly be cheaper than its “real” value (because of the large number of share in the market).

Since Statman’s definition was referring to two different points, let’s now consider the fact that some investor actually beat the market and this almost systematically. I think notably about Warren Buffet. He said to the Financial Times that “Observing correctly that the market was frequently efficient; they [academics, investment professionals and corporate managers] went on to conclude incorrectly that it was always efficient. The difference between the propositions is night and day.” 

In this case, the difference between the two models is huge. Indeed, as Warren Buffet proves it for 50 years, we don’t need the market to be always efficient. He made his money from the part of the market that is infrequently inefficient! He keeps beating the markets every time he invests… Therefore, I don’t think that having a market always efficient would be a good thing. Indeed, if markets were always efficient, it would mean that no one can gain from it, or at least not a lot. And if people, like Warren Buffet weren’t gaining more than the average, they wouldn’t be able to invest what they gained in a new market, and therefore keep the markets growing…

However, according to Fama (1970), an efficient market is market in which “prices always fully reflect all available information”. He then defines three forms of market efficiency: the weak form (where historical prices are discussed), the semi-strong form (where the main objective is to see if prices efficiency reflect the publicly available information), and the strong form (where all information are available). Today, we are in the semi-strong form: investors use all the information they have to make decision. However, the strong form remains a utopic form, at least nowadays. Indeed, in our modern societies, having information that others don’t have, gives some kind of power. Information nowadays, especially in a business environment, is a huge source of power.

In conclusion, I don’t think markets can nor should be efficient at all times, since it is their “infrequently inefficiency” that allows investors to gain more than average money.