Price Efficiency

Prices at 7-Eleven and the grocery store are sticky. Not because they’re covered in goo, but because they’re slow to change. Things like stocks are different: very un-sticky, since the prices of stocks ebb and flow daily.

While the theory of price efficiency definitely doesn’t apply to groceries, it does apply to stocks. The idea behind price efficiency is that asset prices are efficient because both sides—buyers and sellers—have all available information about the asset.

The key word here is “available,” since some information is not available. If you were on the inside of Lehman Brothers on the eve of the financial crisis, and you knew everything was about to go downhill, that’s special information you have that the public does not. This is where things like insider trading come into play...sharing info that’s not public in order to make a profit.

When secrets are made public, they then affect prices, adjusting them to this new information. This shows price efficiency at work, with new information changing prices in the market accordingly. If you buy this price efficiency theory, then it’s not possible for investors to earn alpha (extra returns). Basically, you can’t “beat” everyone else in the market because the market is efficient.

Price efficiency is a foundational idea of efficient market hypothesis (EMH), which purports that efficient prices mean efficient markets, and that only current information (not past info) will determine which way prices are likely to go.

How low (or high) can they go?