If all participants in a market are fully rational, then prices reflect information quickly and completely. This is called informationally efficient. In an efficient market, share prices adjust to the expected level of future earnings announcements. Thus, no one can earn abnormal returns by analyzing and reacting to new information that has not already been reflected in price.
The concept of information efficiency is the foundation of the Efficient Market Hypothesis (EMH). There are three forms of efficiency – weak form, semistrong form and strong form. The strongest form is the assumption that security prices fully reflect all public information. This is also the least controversial form of efficiency.
For example, if Taylor and Carrie both want to buy the same album that costs $100, but Taylor is willing to pay more than Carrie, there is consumer surplus equal to the difference in their willingness to pay and the price of the good. Likewise, producer surplus is the difference between the marginal cost of producing a unit of the good and its price to the market.
However, if there is a signal not reflected in the price of an asset that future values are likely to be high, competitive traders will purchase shares on the expectation that those values will increase. As a result, the price will rise until it reflects this new information. Traders will then sell their shares at the new price, thereby earning an economic profit. This type of trading is called momentum investing. If a strategy consistently generates superior risk-adjusted returns, it would provide evidence against the EMH’s strong form of efficiency.