Market Efficiency Explained: Why Stock Prices Behave the Way They Do

NVIDIA smashed records and analyst predictions in late May 2026 when the company announced quarterly revenue of $81.6 billion. You might have expected great news like this to send the AI chipmaker’s shares soaring. Instead, they fell.

That seemingly illogical result illustrates one of the most important ideas in investing: market efficiency.

The concept, popularized by Nobel Prize-winning economist Eugene Fama, is often misunderstood to mean that markets price stocks perfectly. Some investors might point to market crashes, bubbles and dramatic daily swings as evidence that the efficient market hypothesis must be wrong. But that's not what the hypothesis actually says.

Instead, it states that asset prices reflect all available information about those assets. Understanding that distinction can help investors make better decisions—and perhaps avoid costly mistakes.

Markets Price the Future

The stock market is forward-looking: Stock prices are based on what investors collectively expect will happen in the future. Every trading day, millions of investors evaluate earnings reports, economic data, interest rates, new products, geopolitical events and countless other pieces of information. They use this data to constantly update expectations about a company's future earnings and cash flows. The investments they make based on this new information collectively set the price of the company’s stock.

This constant incorporation of new information is why NVIDIA's blockbuster report wasn’t enough to send the stock higher. Investors likely anticipated extraordinary results long before the company released them, and those expectations were already reflected in the stock price. When the news arrived, it fell short of what investors had already priced in.

In much of our lives, we’re comfortable with market prices. We rarely question the price of apples at the store, for example. We just assume that the price is what it needs to be, based on supply and demand.

Stocks often inspire a different mindset. Many investors approach investing as if the assignment is to outsmart the market—finding hidden bargains or identifying tomorrow's winner before anyone else does. Sometimes lightning strikes and the stock they pick jumps. But many investors wind up like the ones who bought shares of NVIDIA just before the quarterly announcement expecting an easy win, only to be sorely disappointed.

Don’t Volatility and Bubbles Prove Markets Are Inefficient?

Investors often ask, “If the market is so efficient, why is it so volatile? And how can the market be efficient when history is full of boom-and-bust cycles like the dot-com and real estate bubbles?”

In fact, volatility is exactly what you would expect from an efficient market. Markets are constantly digesting new information. When information changes rapidly, prices should adjust equally fast. Volatility is evidence that market expectations are responding to new data, not that they're broken.

What about bubbles? The efficient market hypothesis says prices reflect all available information. The problem during bubbles is that investors become overly optimistic about what that information means for the future. A bubble doesn't mean the market failed; it means investors collectively reached conclusions that turned out to be wrong.

Market Efficiency Has Its Limits

Are markets perfectly efficient? Probably not—and that may be a good thing. Economists Sanford Grossman and Joseph Stiglitz famously identified what has become known as the Grossman-Stiglitz paradox: If markets were perfectly efficient all the time, no investor would have any incentive to spend time researching companies or uncovering new information. After all, if stock prices already reflected everything there is to know, there would be no reward for doing the work.

But if nobody gathered new information, markets would become less efficient over time. Markets need a small amount of inefficiency to motivate investors to seek out new information. Those efforts help keep prices reasonably accurate.

Rather than viewing markets as perfectly efficient or hopelessly inefficient, it may be more useful to think of them as highly competitive systems that are constantly moving toward efficiency, even if they never fully arrive there.

What Does This Mean for Investors?

While markets may not be perfectly efficient, you may be better off investing as though they are.

Why? To outsmart the market, you would need to have meaningful information no one else has. In 2025, more than 17 billion shares worth more than $1 trillion traded in the U.S. every day, on average. Those trades were conducted by institutional investors, hedge funds, quantitative trading firms, analysts, economists, sophisticated computer models and professional investors around the world, all competing to identify opportunities before everyone else. Finding something they’ve missed may not be impossible, but it’s vanishingly unlikely.

The belief that markets can be outsmarted can lead to counterproductive behaviors. One of the most dangerous is market timing. This is the strategy of making decisions on whether to buy or sell financial assets by attempting to predict future market prices.

History suggests timing the market is remarkably difficult to do consistently. Studies have repeatedly found that the average equity investor’s returns tend to trail the S&P 500, largely because poor timing decisions caused them to buy after markets had already risen and sell after markets had already fallen.

Accepting the idea of market efficiency can be surprisingly liberating. During periods of high volatility or big market drops, you can rest assured that the market is doing exactly what it’s supposed to be doing as it incorporates new information. Rather than chasing headlines or trying to predict every market move, you can focus on what you can control: maintaining a diversified portfolio, sticking to a long-term investment plan, keeping costs low, and allowing compounding to work over time.

If you have any questions about market efficiency or your portfolio, please don’t hesitate to reach out.