Market Efficiency and Factors Affecting Efficiency

Updated for the 2026-2027 CFA® Level I curriculum.

Market efficiency describes how quickly and accurately security prices reflect available information. This concept sits at the center of the Equity Investments topic area because it shapes how practitioners choose between active and passive strategies. After this note, you should be able to define market efficiency, explain why it matters to investors, and identify the factors that make a market more or less efficient.

Key Takeaways About Market Efficiency and Factors Affecting Efficiency

• Market efficiency measures how well and how fast prices incorporate new information.

• No market is perfectly efficient or perfectly inefficient. Efficiency exists on a spectrum.

• High efficiency reduces the value of active management because mispricing is rare and short-lived.

• Low efficiency creates more opportunity for skilled analysts to find mispriced securities.

• The number of participants, information availability, and ease of trading all affect efficiency.

• Limits to arbitrage, such as short-selling constraints, can keep mispricing from correcting quickly.

• Transaction costs and information costs slow how fast prices adjust to new facts.

What You Need to Know for CFA Level I

• Define market efficiency in terms of the speed and accuracy of price adjustment.

• Explain why market efficiency matters when choosing active versus passive strategies.

• List the factors that increase or decrease a market's efficiency.

• Explain how each factor strengthens or weakens price incorporation of information.

• Recognize that this LOS is distinct from the three forms of market efficiency, which is a separate topic.

Meaning of Market Efficiency

An efficient market is one where prices reflect available information quickly and rationally. When new information reaches the market, an efficient market adjusts prices before most investors can trade on that information for a reliable profit.

Efficiency Is About How Prices Respond to Information

Efficiency is not about whether a price is "correct" in some absolute sense. It is about how fast and how accurately the price responds to new facts. A stock can be efficiently priced and still fall in value if bad news arrives. The test of efficiency is whether the price moved appropriately and promptly, not whether the price went up or down.

Market Efficiency Exists on a Spectrum

Markets exist on a spectrum. Large, heavily traded markets like U.S. large-cap equities tend toward high efficiency. Smaller markets, such as thinly traded small-cap stocks or frontier market equities, tend toward lower efficiency.

Why Market Efficiency Matters to Investment Practitioners

Market efficiency directly affects how practitioners build investment strategies.

Efficient Markets Favor Passive Strategies

In a highly efficient market, security prices already reflect available information. Spending resources on fundamental analysis to find mispriced stocks is less likely to produce returns that cover the cost of that research. This favors passive strategies, such as indexing, because the cost of active management is harder to justify.

Less Efficient Markets Create More Opportunities for Active Management

In a less efficient market, prices may lag behind new information or misprice risk. Skilled analysts who gather and process information faster or more accurately than the market average have a better chance of identifying mispriced securities. This favors active management.

Market efficiency also affects capital allocation. When prices reflect true underlying value, capital flows to the companies and projects that deserve it. When markets are inefficient, capital can be misallocated, funding weaker companies while starving stronger ones.

Factors That Affect a Market's Efficiency

Several structural and behavioral factors determine how efficient a market is. These factors help explain why some markets absorb information faster than others.

Each factor works through the same basic channel. It either makes it easier or harder for informed trading to move prices toward fair value.

How These Factors Strengthen or Weaken Price Incorporation of Information

Efficiency improves when a market has many active participants, timely and reliable information, low trading costs, and few restrictions on arbitrage. Under these conditions, any mispricing draws in traders looking to profit from the gap. Their trading pushes the price back toward fair value quickly.

Efficiency weakens when a market has few participants, limited or unreliable information, high trading costs, or restrictions that stop investors from correcting mispricing. In these conditions, a mispriced security can stay mispriced for a longer period because the mechanism that normally fixes prices is blocked or too costly to use.

Short-selling restrictions are a common example. If investors cannot easily short an overvalued stock, one side of the correcting trade is missing. The stock can stay overvalued longer than it would in a market where short selling is unrestricted.

Worked Example

Scenario. Two stocks trade on different exchanges.

Stock A is a large-cap company covered by 25 sell-side analysts. It trades on a major exchange with high daily volume, low bid-ask spreads, and no restrictions on short selling.

Stock B is a small-cap company covered by one analyst. It trades on a smaller exchange with low daily volume, wider bid-ask spreads, and local rules that make short selling difficult.

Question. Which stock is more likely to have efficiently priced shares, and why?

EXPLANATION

1. Compare participant coverage. Stock A has far more analysts monitoring new information, which increases the odds that new facts get priced in quickly.

2. Compare trading costs. Stock A's higher volume and tighter spreads make it cheaper to trade on new information, encouraging price correction.

3. Compare arbitrage limits. Stock A allows short selling, so investors can trade against overvaluation. Stock B's restrictions block this correcting mechanism.

Stock A is more likely to be efficiently priced. It has more participants, better information flow, lower trading costs, and no meaningful limits to arbitrage.

Stock B is more likely to experience periods of mispricing that persist longer, since fewer people are analyzing it and the tools needed to correct mispricing are limited.

Common Exam Traps

Confusing market efficiency with the forms of market efficiency

This LOS covers the definition and the factors that affect efficiency. The weak, semi-strong, and strong forms test a different, more specific framework. Do not blend the two on exam day.

Memorizing the factor list without applying it to the facts in the question

The exam often gives a scenario, such as a stock with limited analyst coverage or short-sale restrictions, and expects you to identify which factor is at play, not just recite the list.

Assuming efficient means "correctly priced forever.”

An efficient market adjusts quickly to new information. It does not mean prices never change or that the market predicted the news in advance.

Giving a conclusion about efficiency without citing the reason

If a question asks whether a market is more or less efficient, always tie the answer back to a specific factor, such as participant numbers, disclosure quality, or arbitrage limits.

Practice Question

An analyst is comparing two emerging markets. Market X has strict capital controls that limit foreign investors from taking short positions. Market Y has no such restrictions and allows both local and foreign investors to short freely.

All else equal, which market is more likely to correct a case of stock overvaluation quickly, and why?

1. Market X, because capital controls protect domestic investors from volatility

2. Market Y, because unrestricted short selling allows investors to trade against overvaluation

3. Both markets equally, because overvaluation always self-corrects over time

FAQs About Market Efficiency and Factors Affecting Efficiency