Informational Efficiency
Also written Informationally efficient market
How fully and quickly security prices reflect available information. It is what "market efficiency" usually means, as against operational efficiency, which is about transaction costs.
In plain language
"Market efficiency" can mean two things.
- Operational efficiency is about the cost of trading. It asks how cheap it is to buy and sell.
- Informational efficiency is about prices and information.
The workbook notes that the term market efficiency is mostly used to mean informational efficiency.
In everyday talk, an informationally efficient market is one where prices always "fully reflect" the latest information. The popular short version is that market price equals fair value.
The technical definition is more careful. In an efficient market, the price is an unbiased estimate of the true value. That means it is not tilted one way or the other. The price need not equal true value. But any gaps must be random. A gap is just as likely to be above value as below it. And it must not be linked to anything you can observe in the market.
So no investor should be able to find cheap or dear securities again and again, whatever method they use.
How it works
Two workbook illustrations (Chapter 13, section 13.1). In an efficient market:
- a stock with a PEG ratio below 1.0 is no more or less likely to be undervalued than a stock with a high PEG ratio;
- no technical indicator would help identify an undervalued or overvalued stock.
Price versus value (section 13.1.1). If an investor believes the market is efficient, the market price is taken as a good measure of value, and trades happen only for liquidity and rebalancing. If not, the investor estimates intrinsic value and trades when it differs from price, seeking alpha.
Degrees of efficiency. Fama (1970) divided the efficient market hypothesis into weak, semi-strong and strong forms, according to the information set prices reflect: historical market data; plus all public information; plus insider information.
The internal contradiction (section 13.5.3). Markets do not become efficient on their own. They become efficient because many profit-maximising participants believe the market is not efficient and trade to beat it. Efficiency therefore needs a deep and liquid market.
Why it matters for index funds (section 13.5.4). When it is hard to beat the market, "be with the market and reduce the transaction" — minimising transaction costs and tax improves net returns, which helps explain the growth of index funds.
A worked example
Illustrative figures. Two listed FMCG companies trade on the NSE.
| Company A | Company B | |
|---|---|---|
| Price | ₹500 | ₹800 |
| PEG ratio | 0.8 | 1.6 |
An analyst's rule says: "buy PEG below 1". In an informationally efficient market, the rule should not work consistently. Company A's low PEG is public information already in the price. A might turn out undervalued this year, but B is just as likely to be the undervalued one next year.
Now suppose A's true value (unknowable in practice) is ₹540 and B's is ₹760. A is 7.4% below value (40 ÷ 540) and B is 5.3% above (40 ÷ 760). That does not contradict efficiency. What would contradict it is a pattern — low-PEG stocks being systematically below value, so the rule earns abnormal risk-adjusted returns year after year.
That is why an investor with ₹25 lakh who believes the market is informationally efficient buys a low-cost index fund rather than paying for stock selection.
Why NISM asks about it
Chapter 13 is titled Concept of Informational Efficiency and is worth 5 marks in the syllabus outline. Section 13.1 contrasts informational and operational efficiency and gives the technical definition; section 13.2 covers the random walk and fair game formulations and Fama's three forms; section 13.5 covers implications for technical analysis, fundamental analysis and index funds. Chapter 13's sample questions ask which price behaviour would be inconsistent with an efficient market and test statements about what efficient markets require — both answerable from the definition above.
Common exam traps
- Efficient does not mean price always equals value. Technically, deviations must be random and unbiased. "Price adjustments are biased" is inconsistent with efficiency.
- Informational ≠ operational efficiency. Operational efficiency is about transaction costs; a market becomes operationally efficient as the cost of transacting falls.
- "Market efficiency" in the exam means informational efficiency unless stated otherwise.
- The internal contradiction: efficiency requires many participants who believe the market is not efficient.
- Weak form = historical market data; semi-strong = plus all public information; strong = plus insider information. Each form encompasses the one before.
Where this is taught
Free preparation for NISM Series XXI-BRelated terms
- Efficient Market HypothesisThe proposition that share prices already incorporate and reflect all relevant information — which, if true, leaves nothing for an analyst to find by studying that information.
- Index fundsA passive open ended scheme that replicates or tracks a specific index, investing at least 95 percent of total assets in that index's securities, bought and redeemed from the fund rather than on an exchange.
- Market anomalyA pattern of returns that departs from what an asset's fundamentals and risk — as measured by CAPM or another pricing model — say it should earn, and so contradicts market efficiency.
- Random Walk HypothesisThe early form of the efficient market model: security price changes occur randomly, so successive one-period returns are independent and identically distributed.
- Semi-strong-form EfficiencyThe hypothesis that prices reflect all historical and publicly available information and adjust rapidly to news — so neither technical nor fundamental analysis earns above-average risk-adjusted returns.
- Strong-form EfficiencyThe most extreme form of the efficient market hypothesis: prices reflect all historical, public and insider information, so no group of investors can earn above-average risk-adjusted returns.
- Weak-form EfficiencyThe hypothesis that current prices already reflect all historical market information — past prices, returns and volumes — so technical analysis cannot earn above-average risk-adjusted returns.
- Fair Game ModelEugene Fama's 1970 framing of the efficient market hypothesis: current price fully reflects available information, so no investment strategy can consistently earn above-average risk-adjusted returns.
- Operational EfficiencyHow cheap it is to transact in a market — the cost of carrying out trades — as distinct from informational efficiency, which asks whether prices already reflect all available information.
- Standard financeThe traditional view of finance built on rational, self-interested investors with full information — the baseline set of assumptions that behavioural finance was developed to challenge.
- Overvalued securityUnder CAPM, a security whose estimated return plots below the Security Market Line — it is expected to earn less than its systematic risk warrants under market equilibrium.
- January effectA market anomaly in the US: year-end tax selling pushes prices down in late November and December, and the buying back in early January pushes them up — a pattern inconsistent with market efficiency.
- Internal contradiction of efficiencyThe paradox that a market can only become informationally efficient if enough participants believe it is not — because it is their search for mispricing that drives prices to fair value.
- Unbiased EstimateThe technical definition of an efficient market price: the market price is an unbiased estimate of a security's true value, so deviations are random rather than one-sided.