Inefficient Market
The term refers to a market where financial assets or commodities fail to reflect their actual value
What Is an Inefficient Market?
An Inefficient market is a market in which a financial asset or a commodity fails to reflect its actual intrinsic value. In other words, it defies the efficient market hypothesis (EMH) laws. We will learn more about the EMH in the upcoming sections.
Now we know that every market has some or other inefficiency to an extent, but when a call displays no efficiency at all, then it is a market failure.
Under this hypothesis, the security portrays its true value to the participants of the financial market, unlike in an inefficient market. In such a market, non-behavioral finance comes into play.
We will talk about the concept of non-behavioral finance in the next section as we try to grasp more about inefficient markets. As mentioned above, this kind of market disobeys the rules or efficient market hypothesis or EMH.
An EMH is a financial economic theory that states that all the available securities open to the market players for trading reflect all kinds of information in their current prevailing price.
The core pointers that define this theory are based on the assumptions of a perfect market wherein there are no transaction costs, information is available to all the investors, participants of the market have similar expectations, and investors, being rational-minded, behave rationally.
Thus, corresponding to an efficient market. However, all this is not true in the case of markets that work on inefficiency.
Key Takeaways
- An inefficient market deviates from reflecting true asset values, contrary to the Efficient Market Hypothesis (EMH).
- EMH assumes a perfect market with no transaction costs, universal information, similar expectations, and rational behavior, which may not hold true in inefficient markets.
- Inefficiency exists in varying degrees across markets due to factors like non-public information, diverse analytical approaches, and distinct investor behavior, leading to disparities in stock valuations.
- Lack of information and increased volatility in inefficient markets pose challenges, creating opportunities for profit but also substantial losses.
Understanding Inefficient Market
To understand the true essence of this kind of market, we must understand the economic importance of an efficient market.
This theory is based on the Efficient Market Hypothesis or EMH, which comes in three basic forms: weak, semi-strong, and strong.
- The weak form means that the market securities are affected by the historical information associated with the stock, including what returns it has had in the past.
- The semi-strong suggests that the security price reflects the historical data as well as the current prevailing information about the security.
- At last, the strong form portrays all the public as well as not public information available concerning the stock.
All these components combined suggest that all the participants have a fair chance at earning profits on the security with the help of all the information available to them. In return, it makes it a tad bit tough for them to outperform the market.
Therefore, there could be scenarios where one loses a lot of money while the other gains plenty.
However, this only sounds good in theory. It is to be kept in mind that in the real world, these assumptions may not stand true like the fair availability of the market information to all the participants.
All the investors in a company are not public, but there are also many high net-worth individuals, private owners, and institutional financial investors (FIIs) having a stake in the company and have many edges due to the inside information that they can access.
Moreover, every investor or analyst has distinct ways of analyzing and valuing security thus, leading to dissimilar investment decisions.
Consequently, almost every market has a fraction of inefficiency in it, making it paramount for one to grasp a cognition of how an inefficient market works.
The former market had the investors conned that the internet-based companies were to show tremendous growth in the upcoming times. People did not pay heed to the little or, in fact, no growth of these companies and still kept on investing in the industry.
This perception of market players led the bubble to explode when the market finally experienced the recession, and the share prices reflected their actual price.
Similarly, in the latter recession, the sector affected the most was the real estate market. This slump was witnessed by various securities backed by housing loans, among other derivatives.
Soon, when the securities boomed to the maximum potential they had, the bubble finally burst with the onset of a sharp fall in the prices of securities, leading to a recession.
Advantages of an Inefficient Market
Let us look into some pros and cons of an inefficient market.
The advantages of an inefficient market are:
1. Potential for Excess Profits: One of the advantages of participating in this market is that there is a possibility of earning excess or unusual profits.
This, again, points out many factors that may render some investors an edge over other investors due to any insider information or a unique strategy that may have been employed by them to assess the value of the security they are dealing with.
The concept of value trading or value investing can be of benefit here as for the stock that other investors may be underestimating, other investors who form strategies to get a fair idea of the value of that stock and win an edge over other participants in the market.
2. Utilizing Growth Investment Strategies: Another advantage of trading in this market could be analyzing stocks with the help of growth investment strategies.
Under such a strategy, an investor would carefully scrutinize the company's growth capabilities for the future and then decide whether to invest in the same or not.
These are some of the ways that could result in profitable trading in an inefficient market.
Disadvantages of an Inefficient Market
Now, what could be the disadvantages of trading in this market?
The ones explained below are pretty obvious, given the characteristics of this market.
1. Limited Analytical Precision: The loss of information makes it a tedious task for investors to analyze the potential returns on the securities quantifiably. Thus, any major news that may or may not is even remotely related to the company can drastically affect the volatility of the stock price in a short period.
2. Arbitrage and Speculation Opportunities: Corresponding to the same reason, this can open a small window of a huge potential profit-making chance, the benefit of which could be enjoyed by the arbitrageurs and speculators who are prominent players on the market.
Any hurried decision made by these categories of investors can lead to an immense amount of losses in the market. Therefore, with the possibility of bagging huge amounts of profits comes the possibility of incurring huge losses as well.
These are some of the pros and cons of playing in a market with less information and more probability of volatility due to any unanticipated factors.
How to trade in an Inefficient Market
In an inefficient market, trading practices will be different from those in an efficient one.
Explaining on the same lines as mentioned in the section above, let us continue with the ways of trading in such a market.
1. Arbitrage
The first one is arbitrage, which means simultaneously dealing in financial securities to gain from the price differences occurring at very small intervals of time.
Now, how can one perform arbitrage with less chance of making losses on the transaction? The spatial arbitrage method is effective for this.
One can trade the same security in different markets, this is called spatial arbitrage.
That means if a trader buys a brick of gold from the markets located in UAE at a lower price and sells it in the Indian market at a higher price currently prevailing there, they can make a profit of the amount equal to the difference between the foreign exchange rate of the two currencies.
2. Speculation
The second one that we will discuss is called speculation.
Note
Speculation, in trading, is a financial transaction that carries a slight chance of bearing losses but also has the potential of gaining huge gains or profits on the trade.
In such a market, speculation about the commodity prices occurs for deciding whether to buy or sell the trade. The buying of the tradeable item occurs when the price is expected to rise shortly, and selling takes place if the price is expected to plummet.
An investor can speculate in such a market by having insider information about the firm and knowing its next move so that the investor can determine if it'll be profitable or loss-making to invest in the security.
Investors can also deploy learnings from their past experiences and make their next move. They can also assess the stock movements based on the kind of news updates regarding the firm and related to it in any way.
3. Sentiment Analysis
The third kind can be sentiment analysis. Sentiment analysis is a way of ascertaining the investor or market attitude towards a particular stock or security with the help of various factors related to the security.
This method usually uses natural language processing or NLP, which are the computer processing languages used in machine learning. The aim here is to obtain any kind of information from data that is not structured in a way that humans could deduce to gain any insight into it or draw any conclusions based on it.
Thus, an algorithm comes into play and is used to infer if the market is going to go bullish or bearish shortly.
Now that we have looked into the various ways in which one can trade in such a market condition.
Conclusion
Even if an inefficient market seems to be an inadequate and inappropriate market, it is indeed a great opportunity for an investor to acquire a large number of profits, given that they have an edge over other market participants.
On the other hand, if a market is perfect and efficient in all ways and all the market players have all the information available to them fair and square, then it will be almost impossible for the people to outplay any other investor in the market.
In other words, in an efficient market, the actual value of the securities will be always known to the market players and consequently, no one will gain from the trades they will make.
From the discussion made so far, it is understood that real-life stock markets are a blend of efficient and inefficient markets’ attributes.
This means that the securities available in the financial market for trading are assumed to have been priced equally. Consequently, the real-life market scenario is neither fully efficient nor fully inefficient.
This renders the market players a fair chance of drawing a conclusion based on stock analysis and making decisions accordingly.
Researched and authored by Anushka Raj Sonkar | Linkedin
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