How to Be a Successful Investor - Essay Example

How to Be a Successful Investor The primary motive for putting or investing money into the stock market is to get superior return on it. Investors not only try to get return, but also to outperform or in other words, to beat the market return. The purpose of writing this paper is to study the concept of market efficiency in terms of efficient market hypothesis (EMH). It also includes three basic forms of market efficiencies as put forward by Eugene Fama. In this paper, focus is given to the evidences in favor or against the theory that movement of share prices is truly dependent on the information available regarding stock and market. Market efficiency Eugene Fama in 1970 developed the concept of market efficiency on the basis of EMH (efficient market hypothesis). He suggested that at any given time the prices of stocks are purely dependent on the information present in the stock market regarding stock or overall market (Moyer, McGuigan & Kretlow 2008). He also concluded that no one can efficiently predicts the exact future return on any stock because no one has access to the information which is not easily be predicted or available to everyone else (Damodaran 2002). Fama divided efficiency of market into three levels: Strong-form efficiency Shows that stock price truly reflects all the information available, whether it is public or private. Investors did not get any additional value because it is quite impossible to predict the prices. Even the availability of insider information does not benefit the investor in any way (Moyer, McGuigan & Kretlow 2008). Semi-strong efficiency Movement of asset prices truly reflects the availability of public information; therefore investor having insider information gets the investing advantage. Investor does not get any stock advantage through any fundamental or technical analysis. Weak form efficiency  Type of efficiency which states that today’s Prices of assets and securities shows the reflection of past prices. Therefore, technical analysis is useless to predict the prices in order to beat the market (Chandra 2008). Efficient market hypothesis (EMH) is also called as Random Walk Theory (Hebner 2006). This theory suggests that the movement or fluctuation of stock price is a true proposition of all the related information regarding the value of the company that is available in the market. According to this theory nobody earns profit more than the overall return of the market. In other words it can be said that depending on the available information everyone earns the same level of return in the investment of stock. There are some critics on this theory that are related to fundamental and electrifying issues of finance. For example, why price of stock change frequently and what are the factors that cause this change. All the stock related information has very important value for both investors as well as financial managers (Cai 2009). The concept of “Efficient market “was first developed by Eugene Fama in 1965 and he said that “in an efficient market, on the average, competition will cause the full effects of new information on intrinsic values to be reflected "instantaneously" in actual prices.” (Arffa 2001) The primary target of all the investors and finance managers is to invest in the stock that outperforms the market and provide more return as compared to other stocks. Similarly, most of the investor selects the securities that are undervalued having expectations that there price will beat the market, and in the end they gets their desired return. All these decision are based on different valuation techniques of stocks, future expectation and predictions depending on the available information. Effective use of the valuation techniques and prediction enables investor to get more return on the investment made. EMH presumes that no one can outperform the market on the basis of predictions. If a manger of any mutual fund company with total assets of 10 billion increases the returns of the funds, after less of all the transaction and research related cost, equals to 1/10th of 1 percent, would result in the total gain of $10 million. EMH asserts that all these techniques are not useful because the return does not exceeds the costs incurred (cost in terms of transaction and research). The Efficient Market Hypothesis (EMH) shows that profit earned through predictions are too much difficult and unlikely to happen (Bhole 2009). Changes in the prices are the result of advent of new information. Efficient market is the one in which prices of the stock and securities adjust rapidly without any influence of the new information. As a result, the prevailing prices of securities truly reflect the present information at any particular point in time. Therefore, it cannot be assumed or said that the prices of certain security is too low or above. Prices of security rapidly adjusts prior to its trade done by financier or profit through the availability of any sort of new information. The primary reason for the subsistence of efficient market is the strong rivalry among the financiers to get profit through the availability of new piece of information. It is considered as fair and valuable to identify or evaluate the under-priced or over-priced stocks on the basis of available information and logical facts. Because the basic objective of any investor is to buy stock at price less than its value, and to sell stock to get more than its actual worth. But, most of the people spend unnecessary time and capital for the sake of getting “mis-priced” stocks. It is a natural phenomenon, as more and more competition among the analysts in effort to get the advantage of under and over-valued securities, there would be fewer chances for finding or exploiting of mis-prices securities. So in this condition of equilibrium, there will be a relatively few analysts or investors who will be benefitted through detection of mis-priced securities, typically by chance. For the greater part of financiers the payoff of information scrutiny will not offset the transaction cost. There are certain implications of EMH that are much crucial, such as “Trust market prices”. For any particular point in time, the prices of all the stocks and securities mirror the true and flaxen picture of the available information. Therefore, it can be concluded that efficient market is “reasonably priced”. There are no chances for fooling investor and he obtains exactly what he pays for. Fair pricing of securities does not mean that all the investors will perform similarly, nor the rise or fall of the stock prices will remain same. According to the theory of capital markets, the anticipated return of every security is mainly a function of its associated risk. The current price of any security reflects the present value of all the potential cash flow that is estimated to be earning by the security. The current price of security also includes other factors such as liquidity, volatility and chances of insolvency. So, change in the prices of securities is random and erratic, because the predictability of new information is almost impossible. Therefore price of securities moves arbitrarily. There are some critics about the functioning of efficient market. Debatably, in stock market where large number of participants interacts with each other, should be unbiased towards the prices irrespective of any new information. Much of this criticism is based on several false judgments, improper justifications and myths regarding EMH. There are several myths regarding EMH, such as Myth 1: EMH focuses on the concept that none of the investor can outperform the market by earning heavy return as compare to others. But, still there are some famous individuals such as George Soros, Warren Buffett, and Peter Lynch who have earned comparatively more thus making EMH incorrect. After studying this myth, the overall concept of EMH has been changed, because there are some facts and figures that do not comply with the theory of EMH. EMH is based on the principle that one should not anticipate to outperform the market constantly. Investors can still outperform the market with the availability of new information (Arffa 2001). Myth 2: EMH also shows that doing financial research and analysis is just useless and waste of resources, because it would not help investors or analysts to get outweighed return (Arffa 2001). Most of the financial analysts put certain techniques to evaluate the stock and security prices and make portfolios to determine the suitable return on the investments made. They devote necessary time, effort and capital for sophisticated scrutiny of pricing of capital. Therefore, any sort of profit attain by analyst during trading of “mis-priced” securities includes costs, such as financial, transactional and research related cost. Myth 3: EMH claims that latest information reflects the prices of security. But, sometime the fluctuation of prices is too frequent and it dramatically changes in every minute, hour and day. Therefore, the concept of EMH is wrong. The continuous fluctuation in the security prices shows that market is acting efficiently. Value of securities is affecting by the arrival of new information and market is in continuous state of making adjustments to gain the equilibrium position. So it cannot be concluded that prices do not change, because new and pertinent information is persistently arriving and it will continue to be happen in future (Arffa 2001). Myth 4: EMH presumes that all the investors trading in the market must be trained, knowledgeable and have skills to analyze the new information related to stock prices. Still, there are vast number of investors who are not trained enough to be considered as financial expert. Therefore, this point is also against the EMH (Statman 1991). Much of the earlier evidences show that stock markets are well organized and consequently, investors get very little for his management strategies. Therefore all the efforts that investor made to hammer the market are unproductive and on the other hand it reduces the return by increasing other costs, such as management, transaction and tax etc. The basic motive of all the investors is to maximize their returns. Large number of investment analysts and financial experts publish number of books and develop theories regarding ways that can outweigh the market. But investment strategies no longer work, because in an efficient market the prices of securities changes frequently and then it comes to normal level on its own. Consequently, the return that customers get compensates their operational cost, time value of money and the jeopardy that they put up with (Mishkin 2009). In real world, financial markets cannot be totally proficient or incompetent. But, the arrival of new information and communication technology has made it possible for the market to gain more efficiency and effectiveness. Information technology has enabled investors to quickly adjust themselves as soon as new information enters into the market. Effective and agile ways of disbursing information and electronic trading have developed more accuracy in the market (Moyer 2009). Finally, it can be concluded that the trade markets are “informationally efficient” and all the securities, stocks and bonds traded in the market reflects he acknowledged information. EMH gets the support of all experimental evidences and also suggest that trade markets are highly efficient. Efficient market hypothesis also shows that it is quite impossible to get advantage return on the information that is available to the public already, apart from fortune. So, there are some myths and misconceptions that have to be answered by this theory there is still more debates required on efficient market hypothesis, because it is too controversial and not yet proved to be efficient enough. In factual investment world, there are some clear arguments that are not in favor of the efficient market theory. However, EMH is considered as one of the best definition that effectively clarifies the picture of stock price movement in the market. List of References Arffa, R.C. 2001, Expert Financial Planning, John Wiley and Sons, New York. Bhole, L. M. and Mahakud, J. 2009, Financial Institutions & Markets, 5th edn, Tata McGraw-Hill Education, New Delhi. Cai, W 2009, How to Be a Successful Investor, Armour Publishing Pte Ltd, Kent Ridge. Chandra 2008, Investment Analysis, 3rd edn, Tata McGraw-Hill Education, New Delhi. Damodaran, A. 2002, Investment Valuation, 2nd edn, John Wiley and Sons, New York. Mishkin, Frederic S. 2009, Financial Markets and Institutions, 6th edn, Pearson Education India, Noida. Hebner, M.T. 2006, Index Funds, IFA Publishing Inc, California. Moyer, R.C., McGuigan, J.R. and Kretlow, W.J. 2008, Contemporary Financial Management, 11th edn, Cengage Learning, Mason. Moyer, R. Charles. 2009, Contemporary Financial Management , Cengage Learning, Boulevard. Statman, M. 1991, Efficient Capital Markets. II, Journal of Finance, vol 46, no. 5, p. 1575–1617. Read More