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Efficient markets theory
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Efficient markets theory

Efficient markets theory is a field of economics which seeks to explain the workings of capital markets such as the stock market. According to the theory of efficient markets, in an efficient market the prices of stocks will reflect a rational assessment of the true underlying worth of stocks (i.e., rational expectations); the prices will have fully and accurately discounted (taken account of) all available information (news).

The theory assumes several things including perfect information, instantaneous receipt of news, a marketplace with many small participants (rather than one or more large ones with the power to influence prices). Since the theory assumes that news arises randomly in the future (otherwise the non-randomness would be analysed,forecast and incorporated within prices already), then the theory predicts that stock prices will approximate to a stochastic process pattern of price movement and that technical analysis (and statistical forecasting) are likely to be fruitless.

This efficient process of price determination can be contrasted with an inefficient market in which, according to the theory, the pre-conditions for efficient pricing (perfect information, many small market participants) have not been met and prices may be determined by factors such as insider trading, institutional buying power, mis-information, panic and stock market bubbles and other collective cognitive or emotional behavioral biases.

A central part of this theory is the Efficient market hypothesis.

 
See also: insider trading, technical analysis, efficient market theory, behavioral finance