Subject 2. Forms of Market Efficiency PDF Download
There are three versions of the Efficient Market Hypothesis (EMH); they differ in their notions of what is meant by the term "all available information."
Implications of EMHs
The assumptions of technical analysis directly oppose the notion of efficient markets.
- The process of disseminating new information takes time.
- Stock prices move to new equilibriums in a gradual manner.
- Hence, stock prices move in trends that persist.
Therefore, technical analysts believe that good traders can detect the significant stock price changes before others do. However, as confirmed by most studies, the capital market is weak-form efficient as prices fully reflect all market information as soon as the information becomes public. Though prices may not be adjusted perfectly in an efficient market, it is unpredictable whether the market will over-adjust or under-adjust at any time. Therefore, technical analysts should not generate abnormal returns and no technical trading system should have any value.
Fundamental analysts believe that:
Therefore, by accurately estimating the intrinsic value, a fundamental analyst can achieve abnormal returns by making superior market timing decisions or acquiring undervalued securities.
Fundamental analysis involves aggregate market analysis, industry analysis, company analysis, and portfolio management. However, using historical data to estimate the relevant variables is as much an art and a product of hard work as it is a science. A fundamental analyst must do a superior job to predict earnings surprises to beat the market.
Since the capital markets are primarily efficient, the majority of portfolio managers cannot beat a buy-and-hold policy on a risk-adjusted basis. However, on many occasions the market fails to adjust prices rapidly in response to public information, and superior investment performance is likely to be achieved through active security valuation and portfolio management. This achievement relies on superior analysts who can time major market trends or identify undervalued securities. Hence, the decision of how one manages a portfolio (actively or passively) should depend on whether the manager has access to superior analysts.
If a portfolio manager has access to superior analysts, he or she can manage a portfolio actively, looking for undervalued securities based upon superior fundamental analysis (including predicting earnings surprises) and attempting to time the market when asset allocation is shifted between aggressive and defensive positions. The portfolio manager should ensure that the risk preferences of the client are maintained.
If a portfolio manager does not have access to superior analysts, he or she should:
- Determine and quantify his risk preferences;
- Construct the appropriate risk-level portfolio by dividing the total portfolio between lending or borrowing risk-free assets and a portfolio of risky assets;
- Diversify completely on a global basis to eliminate all unsystematic risk;
- Maintain the specific risk level by rebalancing when necessary;
- Minimize taxes and total transaction costs (reduce trading turnover and trade relatively liquid stocks to minimize liquidity costs).
The Rationale of Index Funds
If companies don't have superior analysts who can beat the market, then the analysts should simply attempt to match the market at the lowest cost. To achieve a market rate of return, diversification in numerous amounts of stocks is required, which may not be an option for a smaller investor. Index funds (also referred to as market funds) are security portfolios designed to duplicate the composition and therefore the performance of a selected market index series.
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