One of the hallmarks of free markets, including financial markets, is efficiency. After one of the most volatile stock market weeks in history, many are questioning whether “efficiency” is a quaint notion of the past.

Here’s what happened with the Dow Jones industrial average, the first time it had four consecutive daily moves of 400 points or more.

August 8 – down 635 points, -5.5%. S&P, one of three major credit rating agencies, cuts the rating for US government debt from AAA to AA+. (This was hardly a surprise, having been discussed for months, and the other two rating agencies maintained their AAA ratings.)

August 9 – a 652 point reversal to end up 403 points, +4.0%. In a very unusual move, the Fed announced that it would likely keep short-term interest rates at their current low levels into mid-2013. (The administration’s response to the credit downgrade was to point out that S&P had made a $2 trillion error in their calculations. And the low rates have already been in effect since December, 2008 without the intended growth effect.)

August 10 – down 521 points, -4.6%. The strength of European banks, particularly French banks, was a major concern. (Rumors concerning French banks were partly driven by a series of fictional articles in a French paper, but the articles used the actual names of French banks and banking executives.)

August 11 – up 424 points, +4.0%. First-time unemployment claims were 395,000 for the prior week, better than expected. (Those claims have bounced around the 400,000 mark for months and nothing in the report indicated lasting strength in hiring.)

While these economic developments are worthy of consideration by investors, why was the market reaction so dramatic and arguably out of proportion with the long-term significance of the news?

Part of the problem may be that it’s August, when many market participants are assumed to be on vacation and not concerned with the markets. These days, that is more likely with individual than institutional investors.

The more likely factor is trading by hedge funds and computer-driven trading programs. According to the Tabb Group, a financial markets research firm, high-frequency trading accounted for 65% of daily trading volume for the week of August 8. Many of these programs follow the same technical analysis techniques, based on charts, market levels and trading patterns, so the moves in the market are magnified and self-reinforcing. This downward pressure can lead to a “liquidity black hole” where there is so much selling pressure that any other influences are completely overwhelmed. A scary example is August 8, when every stock in the S&P 500 ended down for the day.

The idea of an “informationally efficient” market is largely based on the work of Eugene Fama in the 1960’s. The strongest form of efficient market theory holds that all information, both public and private, is reflected in share prices. Weaker versions maintain that prices adjust rapidly to newly available public information and that future prices cannot be predicted by analyzing past prices. In an efficient market an investor cannot achieve returns greater than the market average given the level of risk assumed and the information available at the time the investment was made.

Given the speed of trading in today’s markets, it is hard to accept the idea that prices at all times reflect underlying fundamental value and the knowledge and expectations of all investors. Indeed, it seems that efficient markets more likely happen over a longer time period as the daily gyrations of short-term trading create a trend that does reflect fundamental value.

Another function of an efficient market is the flow of capital to investments that offer the proper combination of risk and return. If the return is greater than the perceived risk, more investment will force prices up and returns down; likewise, if risk is greater than returns, investment will flee until prices drop and returns rise to appropriate levels. In practice, this flow usually overshoots because of the herd mentality of many investors simply following the crowd. The technology craze of the 1990’s is a good example. Early investors saw significant opportunity for growth; later investors bid prices to ridiculous levels without consideration of the increasing risk. When the tech bubble burst, investment flowed out in search of the next opportunity (real estate, which of course created an even larger bubble).

Individual investors’ patience is understandably being worn thin by daily market whiplash. Steady reports of the billions of dollars being made by hedge fund managers supports the suspicion that the markets have become a gambler’s game that is rigged against the small players. This distrust, combined with fear of a weakening economy, may have led individuals to inefficiently allocate their investment portfolios.

In 2009, even as the stock market began a fairly steep recovery from its March low, investors poured a record $425 billion into low-yielding bond mutual funds. In 2010, the average US stock fund returned 17%, but individual investors actually took more money out of stock funds than they added. Instead, they dumped another $222 billion into bond funds that are yielding barely the rate of inflation. Research firm DALBAR, in its 2011 investor behavior analysis, determined that for the 17th consecutive year mutual fund investors did worse than the market averages due to decisions driven by psychology rather than analysis.

Individuals would be best served by listening to economic developments and incorporating them into a long-term economic view while ignoring any short-term market reaction. At the same time, an investment strategy that is as objective as possible based on goals and risk tolerance will help avoid the damage done by inefficient emotional decisions.