Internal contradiction of efficiency

Markets do not become efficient by themselves. Prices only reflect information because people go looking for profit and trade on what they find.

Now follow that through. Why would anyone do the work of hunting for a mispriced stock if they thought prices were already right? There would be nothing to win.

So the necessary condition for an efficient market is that participants believe it is not efficient. They have to think they can beat it.

That is the internal contradiction. Efficiency depends on a large number of people betting that efficiency does not hold.

The workbook draws a practical conclusion from it. This need for many profit-seeking participants is why an efficient market has to be a deep and liquid one.

The argument (section 13.5.3). Markets do not become efficient on their own. It is the actions of participants — sensing profit-maximising opportunities and trading on the basis of information, using some investment strategy to beat the market — that makes markets efficient. So the necessary condition for a market to become efficient is the belief of the participants that the market is not efficient and that they can derive superior risk-adjusted returns by using some scheme or strategy.

To make the market efficient, therefore, a large number of profit-maximising participants must seek out opportunities to beat the market, based on their belief that the market is not efficient. The workbook's conclusion: such internal contradiction promotes the prerequisite of a deeper and liquid market for it to be efficient.

What it explains about the price. Section 13.1 sets out the standard the contradiction serves. An efficient market is one where the market price is an unbiased estimate of the true value. The price need not equal value, so long as the deviations are random — an equal chance of being under or over valued at any point — and uncorrelated with any observable market variable. No investor should then be able to consistently find under-valued or over-valued securities with any strategy.

The mirror-image consequence (section 13.5.4). If the market is efficient, the rational response is to stop searching. A strategy of minimising transaction costs beats one requiring frequent trading, especially over a long horizon. The workbook's formulation: when it is difficult to beat the market, be with the market and reduce the transaction — the premise on which indexing rests. Minimising transactions reduces transaction cost and tax, so returns start off better.

No figure is given. Section 13.5.3 is a purely logical argument. It puts no number on how many participants are enough, and no measure on depth or liquidity. The nearby sample question confirms only that an efficient market requires a large number of profit-maximising investors.

Illustrative figures. Two Indian stocks, each with a fair value of Rs 500 on any careful reading of the accounts.

Stock A — a Nifty 50 constituent. Forty analysts cover it. Three hundred institutions trade it. Daily turnover is Rs 900 crore. A results announcement that should move fair value to Rs 540 is reflected in the price within minutes, because dozens of desks are racing each other to act on it. Every one of those desks is there because it believes it can find an edge. Their collective failure to keep any edge is what makes the price right.

A PMS manager who spends Rs 15,00,000 a year on research to cover Stock A is competing with all forty of those analysts for a few basis points.

Stock B — a thinly traded small cap. One analyst covers it. Daily turnover is Rs 40 lakh. The same news takes three weeks to show up in the price, and for those three weeks the stock trades at Rs 505 while fair value is Rs 540. A manager who does the work can buy 20,000 shares for Rs 1,01,00,000 and be worth Rs 1,08,00,000 when the price catches up — Rs 7,00,000, or nearly 7%, for effort rather than risk.

The contradiction in one comparison. Stock A is efficient because so many people are trying to beat it. Stock B is inefficient because almost nobody is. And the Rs 7,00,000 on offer in Stock B is precisely what will eventually attract enough participants to make it efficient too.

Chapter 13 (Concept of Informational Efficiency), section 13.5.3 (Internal contradiction in the concept of efficiency), sits among the implications of market efficiency for valuation and portfolio management, right before section 13.5.4 on the rise of index funds.

The chapter's sample question 5 tests it directly by asking which statement is false, with an efficient market requires a large number of profit-maximizing investors among the options that are true. Expect a conceptual question on the necessary condition for efficiency, or on why depth and liquidity are prerequisites.

• The condition is belief, not fact. Efficiency needs participants who believe the market is inefficient. A question that says efficiency requires investors to believe the market is efficient inverts the whole argument.
• The contradiction does not disprove efficiency. It explains the conditions under which efficiency arises, and why a deep, liquid market is a prerequisite.
• Random deviations are allowed. An efficient price need not equal true value; it must be an unbiased estimate, with deviations that are random and uncorrelated with observable variables.
• It cuts both ways in practice. The same chapter uses efficiency to justify indexing and to explain why active managers exist. Both conclusions come from the same section of the workbook.
• Do not confuse it with operational efficiency. That is about the cost of transacting. This is about information in prices.