Even if we assume that all information is available to everyone at the same time at no cost is it still possible to outperform an “efficient market”, thus exposing a paradox in the “efficient market” definition.

A competitive market of assets is termed efficient if every market price reflects all relevant information that is available.  So by definition there is no public or private information which will allow an investor to outperform the market. Information includes any possible piece of information that could influence a security price which, for example, includes market information, scientific discoveries, inventions and financial data. The History of the Efficient Market Hypothesis is well documented in a research note by Martin Sewell (2011).

What happens when new information arrives: Can the market instantaneously reflect the information without any transaction happening? In theory this is possible. If for example, a piece of information results in an increase in the value of a security then all sellers of the security would immediately adjust the price at which they are prepared to sell the security to the new fair price, without a transaction happening. So all transactions will always occur at the efficient price.  

As all market prices are always fair in an efficient market, trades can only happen as long as buyers and sellers match up. Market participants would transact due to

  1. investable income received or a need to pay a liability;
  2. a change in the timing and characteristics of the participant’s future liability stream; or
  3. a change in the risk appetite of a market participant.

(See my earlier post)

As soon as a market participant, say Ivan, cannot find a counterparty to whom he can, for example, sell his asset because of one of the above reasons, the market comes to a halt. The only way for Ivan to complete his trade is to provide an incentive for a counterparty, say, Lucy, to trade.

To obtain the required cash to buy Ivan’s asset, Lucy would need to sell one of her other assets to someone who is queuing to buy that asset at its fair price. This trade would change the characteristics of Lucy’s portfolio and so the incentive offered by Ivan should, at least, compensate her for this.

The trade between Lucy and Ivan clears at a price below the fair price. Lucy outperforms the market and Ivan underperforms the market. Therefore, if information is free, the market can only function if it is not “efficient” — the paradox.

Lucy can be seen as a liquidity provider — a service for which she is paid resulting in her outperforming the market. Lucy has outperformed the markets by making this trade, while Ivan has underperformed the market.