Efficient Market Hypothesis and Market Behaviour - Essay Example

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Efficient Market Hypothesis and Market Behaviour Introduction The financial market is usually affected by a number of factors. One main factor that impacts decisions made by investors relates to the availability of information regarding certain businesses or securities…
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Efficient Market Hypothesis and Market Behaviour
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Download file to see previous pages In fact, market prices are frequently nonsensical” (Warren 1984, p17). This statement was made by Warren Buffett in reference to security prices and how they cannot be determined by individuals. To Buffett, market prices often do not make sense, and therefore he argues that financial experts should not dwell on the stocks themselves, but on stock pickers and investors who frequently determine market indices. However, the Efficient Market Hypothesis offers a totally contrasting view to the issue of market indices. The Efficient Market Hypothesis is a financial theory that affirms that it is not possible to ‘beat the market’ since financial markets are believed to be infomationally efficient. In other words, the theory asserts that efficiency in the stock market normally leads to a clear reflection of relevant information on the existing share prices. According to the EMH theory, stocks will normally trade at their fair value on the market, which would make it impossible for traders to buy undervalued stocks or sell them at inflated prices. As such, it would not be possible to do better than the overall market through market timing or even professional stock selection. If an investor wants to obtain higher returns he would have to purchase riskier investments. Believers of the efficient market hypothesis argue that there is no need to look for undervalued stocks or try and predict trends in the stock market through technical or fundamental analysis. Tenets of Efficient Market Hypothesis EMH was a financial theory developed by Eugene Fama in the 1960s. In his 1965 paper, Fama noted that “on the average, competition will cause the full effects of new information on intrinsic values to be reflected instantaneously in actual prices” (Fama 1970, p386) According to the efficient market hypothesis, when one buys and sells securities, they are not using skill, rather, they are “engaging in a game of chance”. EMH was widely accepted until behavioural finances became mainstream in the 1990s according to Hebner (2007). There are different aspects of what should constitute an efficient market and it all depends on the kind of information that is available (Desai 2011). These aspects are grouped into the three forms of the efficient market hypothesis: the weak form, the semi-strong form and the strong form (Fama 1970). The Forms of Efficient Markets The weak form of EMH asserts that historical market prices and data or information are reflected fully in securities prices (Fama 1970). This implies that technical analysis is not useful at all. Analyzing prices from the past according to this form cannot be used to predict future prices. This means that investment strategies that are based on past share prices and data cannot be used to earn excess returns in the long run (Jung and Shiller 2005). What this implies is that if stock prices are random, then it is not possible to use past prices to foretell future ones. In the weak form of efficient markets, information arrives randomly, thereby making stock price changes to occur randomly. Most financial research supports the view that financial markets are weak. The semi-strong form of efficient markets asserts that securities prices reflect any publicly available information as well as future expectations (Fama 1970). If this is the case, then ...Download file to see next pagesRead More
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