Efficient Market Hypothesis

Efficient Market HypothesisContents

TOC o “1-3” h z u HYPERLINK l “_Toc376767859” Efficient Market Hypothesis PAGEREF _Toc376767859 h 1

HYPERLINK l “_Toc376767860” Abstract PAGEREF _Toc376767860 h 1

HYPERLINK l “_Toc376767861” Definition of efficient market hypothesis PAGEREF _Toc376767861 h 1

HYPERLINK l “_Toc376767862” Corporate Insiders PAGEREF _Toc376767862 h 2

HYPERLINK l “_Toc376767863” Security Analysts PAGEREF _Toc376767863 h 3

HYPERLINK l “_Toc376767864” Professional Portfolio Managers PAGEREF _Toc376767864 h 4

AbstractEfficient market hypotheses are basically forecasting tests that reflect the context of sets of information provided. They aim at establishing trading opportunities that are profitable in “real time”. There are however differences that are likely to come up as a result of the constant search for patterns that have to be predicted. All this is done in an attempt to find trading opportunities that can be exploited (Bodie, 2010).

Stable market trends do not persist for longer duration especially when found out by a larger number of interested investors. Formal tests of market efficiency thus become a complicated activity and finding forecast approaches that can be relied on is tough task.

Introduction

Definition of efficient market hypothesisAn efficient market hypothesis is a theory that suggests that, there is an acceptable standard of prices that reflects all information on the market, up to the areas that the marginal benefits of relying and acting on information, do not exceed the marginal cost. It is therefore impossible to outperform the overall market through market timing or expert stock selection. This therefore suggests that the only way an investor can get higher returns is by buying more risk company stocks (Marcus, 2008)

There are mainly three forms of efficient market hypothesis, namely the weak form, semi -strong and the strong form. There are several factors that can cause this difference in the levels of efficiency in market hypothesis.

Although an efficient market hypothesis has not been proved all those involved in modern finance agree that it is an unavoidable factor. A diversified portfolio of securities should earn fair prices if truly the markets become efficient.

The strong form hypothesis is most reliable because it relies on professional managers, insiders from corporate and analysts of stocks. The weak and semi -strong hypothesis have not gained much support because trading rules would not perform better than the buying and selling of policy. The semi -strong hypothesis results are very much mixed and show a price reaction to the irregular announcements and information. The clear seasonal issues, for instance trading in January or Mondays make it difficult for hypothesis in the weak and semi strong forms to be relied on (Allen 2008).

The strong form hypothesis suggests that the stock prices are a reflection of reliable information from both public and private sectors. This therefore implies that the notion of a group of investors beating the market is not true and cannot be justified. All information whether from public or private sources is taken in to account when coming up with stock prices.

The evidence of strong markets as resulted to an increased momentum in the search for information for traders who want to reduce costs resulting from research and trading, while at the same time devoting to a fund that can closely monitor specific market indexes.

The strong form hypothesis uses evidence from insiders though we know it is illegal. But this information nevertheless will be incorporated into the market prices. The illegality of using inside information makes the strong form hypothesis generate just above average profits. It can not be fully exploited. There are various contributions by insiders, security analysts and professional portfolio managers in the validity of strong form hypothesis.

Securities analysts are also keenly monitor the performance of competitors in the sector for example by using financial statements and result over a given period. This will help investors make a good judgement on the company and decide on whether to buy or not. They can also give management suggestions that may prove invaluable to investor. All these make security analysis and their opinions very important in arriving at the strong form market hypothesis as a more reliable option.

Corporate Insiders

It is also referred to as insider trading. Most investors are aware about it but usually believe is an illegal exercise. True there can be legal and illegal conduct in as far as corporate insider trading is concerned. It can be referred to as legal when the officers, employees, directors in a company buy or sell participate in the trading of stocks belonging to the own company. When this happens the stock market security authorities in this case SEC should be notified. This is deemed to be contrary to official duty, confidence and the trust bestowed on them. It will be regarded as misappropriation of the information available t o them by virtue of their association or duties in the company. It is also referred to as tipping.

SEC rules set much deference to liability of such a practice. The insiders are permitted only under particular circumstances and especially if established that the information that they are using is not a factor in making decisions during trading and depending on the existing arrangement, instruction or contract with the company whose stocks are being traded. The rule also gives guidelines in situations where there is none –business relationship between the insiders and the parties interested in investment.

There also has been a misconception that directors and those in upper management are the only ones who have access to such information and most times are the ones liable for prosecution. It is not true. Anyone who has information that is not in public domain can commit such an act and can be convicted. Statistics however indicate that top executives have in the past been found to contribute to the highest number of illegal insider cases.

Brokers, family members, friends employees among other people can be investigated and if proved to have committed the offense could be considered insiders and are subject to prosecution too. Again it is important to note that it is not in all cases where insiders are denied the right to invest. They can d o so under the trading authority guidelines ( Reilly,2008).

The question therefore becomes how an investor can use corporate insider to make profits. The first indicator of when you should buy or sell stock is when you notice that insiders and majorly company executives are buying or selling. It may not mean anything substantial but it is worth probing further. People can sell for a variety of reasons. The strongest likelihood though is that it may be going down. In which case you should also act t o avert a loss. It may not really raise an alarm if one or two employees or executives are engaged in selling their stocks abut an increasing number will have to get you thinking. Many companies majorly issue statements to avoid anxiety among members of the public in situations that they know employees or the compony executives will be selling their stocks.

On the other hand it is simpler to understand why insiders are buying company stocks. No one buys stocks that are likely to perform poorly. In this case the option will be one- they believe the prices will ascend. It may not happen instantly but you can almost be certain the rise will take place in the near future. However investors should not be quick to come up with conclusions.

Security AnalystsMost investors depend on financial analysts and their reports on securities. Trading activities to a large extend also are responsive to recommendations by security analysts. That means even a simple statement or comment in the media by a popular stock analyst is enough to either raise or lower a company’s stock prices. It will not matter if the comment was accurate or not.

Nevertheless there are good reasons financial analysts are still relied on to give recommendations to members of the public and investors on securities and their possible performance. To be gin with, financial analysts are professionals involved in studying company’s trading and are free to rate their respective market performance. They can avail this information to members of public who seek their guidance or broadcast the analysis through any form of media.

Most analysts are specialists in various types of securities for example equities, bonds and many others. Within the specific type of security the analyst can do a particular analysis. For example a security analysis can choose to study the companies involved in mortgage in general or they can choose to pick on a few companies and concentrate their analysis on them. This makes security analysis work comparatively reliable and that is why heir opinions to a large extent affect the stock prices.

Professional Portfolio ManagersIt is not common to find many investors directly dealing with financial assets. In some cases they use professional portfolio managers to do it on their behalf. That explains why they control the majority of financial investments by private investments. There is a long history of fund managers proving their analysis is workable and has been used to earn good financial profit by investors before. The expected returns in financial markets are mainly dependant on asset risks. Portfolio managers therefore believe that the best way to increase the average returns is by taking more risks.

It may not necessarily be a good move. Differentiating between the bad and good investment decisions in a given situation is difficult. However measuring mutual performance of funds will prove that investors involved in a broad market index outperforms a median fund manager. Those dealing with mutual fund have to pay management fees. They will not be liable for these fees when holding the index and this makes it more lucrative for the investor.

Fund managers work with strategies as a result of evaluations based on their view of the market. This line of thought is also shared by the strong form of efficient market hypothesis. For as long as the professional fund managers update themselves on current trading information then it will be easy f or such superior information t o be used to make profits. Fund managers invest a lot in getting the right information that can facilitate their trading on a broad index and thus get good profits.

There is empirical evidence suggesting that certain patterns are very much predictable in the prices of assets the most common being the momentum. Momentum means the prices that are falling are likely to fall further and those that are rising are likely t o go up more. Portfolios of stocks that do well will likely outperform others in the near future. The frameworks under which prospects are sketched out also determine the market trends and prices.

Trading strategies used by portfolio managers such as the return based strategy suggest that stock prices overreact to specific but firm information. It is also believed that there is a reaction to delay of common aspects involved in trading.

The momentum trading strategy used by fund managers suggest that stock prices overreact to specific and firm information. This is according to the return based strategy. The managers therefore only respond to this kind of information and avoid acting on any other element in stock market that may not earn much profit. These are also called contrarian trading strategies.

Hedge funds are activities that are characterised by flexible investment measures on complex securities. They differ with banks because they are unregulated and invest mainly income securities that are fixed. They in addition take considerably risk steps and are more profitable. However they take a quantitative measure of the number of risk ventures they wish to take in a given period. (Reilly 2008)

Generally the objective of portfolio managers is to select stock skilfully. This means those stocks that are likely to outperform in the market and create a portfolio for those stocks.

The analysis takes many forms. There is a technical analysis involving the use of charts that reveal the how future price movements are likely to behave. Public information is also used to select stocks that are undervalued. This is done through a fundamental analysis of private information that puts them in a position to sample out incorrectly valued securities. This essentially means taking advantage of systematic errors to outperform others in the market.

It is reliant on the time horizon of the investor and the philosophy of the portfolio manager in as far as investments are concerned. The client though has to be informed frequently so that they are aware of the position and avoid surprises. The fund managers can also manage multiple portfolios and associated dividends. The market timing funds managers are particularly very helpful (Goetzmann ,2006).

In conclusion the strong form efficient market hypothesis implies that all the information should be reflected in the present prices whether private or public. Obviously there are many reasons why one would not expect the stock markets to be of the strong form. There are also several restrictions on the insider trading that make it very difficult for people to benefit from any information that may have.

Speculation therefore becomes difficult. This already creates barriers for information to reach the people who would use it in stock trading (Houston, 2009). As a result of this situation there will be no enough motivation to spent more resources in order to get personal information. It is therefore not easy for analysts to conclude that prices can reach strong form efficiency. These factors remain a hindrance to that kind of desire.

Bibliography

Bodie, Kane & Marcus (2010), Essentials of Investments, 8th International Edition

Bodie, Z., Kane, A. and A.J. Marcus (2008). Investments, 8th Edition, McGraw-Hill. (This is a more advanced version of the main textbook).

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Brown, K.C. and F.K. Reilly (2008). Investment Analysis and Portfolio Management, 9th Edition, South Western College, International Edition.

Brown, K.C. and F.K. Reilly (2008). Investment Analysis and Portfolio Management, 9th Edition, South Western College, International Edition.

Elton, E.J., Gruber, M.J., Brown, S.J. and W.N. Goetzmann (2006). Modern Portfolio Theory and Investment Analysis, 7th Edition

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