Eugene Famas Efficient Market Hypothesis Theory - Essay Example

?Investment Analysis work 2001 This paper is an essay and offering few arguments in acceptance or rejection of the following ment made by Warren E. Buffet. For the purpose this theory or statement has been compared with Eugene Fama’s ‘efficient market hypothesis.’ Introduction: “When the price of a stock can be influenced by a ‘herd’ on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical” (Hagstrom 1999. p. 65). The above statement justifies that market movements are frequently nonsensical and prices of stocks are influenced by the ‘herd’, which implies to a group that acts upon emotions. ‘Herd’ implies a social grouping of people, who have similar understanding or perception about anything. Here ‘herd’ implies the people, who have the same viewpoint within the stock market. The above statement briefs that market movements are dependent on individuals. If a person buys a particular stock and he is a popular figure in the community and society, then every individual intends to purchase this stock and this is simply because the first person has bought it, not because of the market value of the stock. “Perhaps 100 people were simply imitating the coin flipping call of some terribly persuasive personality” (Buffett n.d. p. 4). The ‘margin of safety’ principle implies that safety should be ensured while buying stocks. Walter has justified that while dealing in the stock market, it should always be remembered that it is other people’s money which is being handled. Therefore it reinforces the ethics to strongly avert losses while dealing in stocks. It should always be remembered that money is real and therefore should be handled appropriately. If the net worth of a business is $1 and it can be obtained at 40 cents, then it aims to generate profit. In the stock markets risks and rewards are correlated because as the stock grows riskier, more are the returns from this stock. Even though a high risk stock would be able to generate more returns, yet a risky stock can also generate less or nil returns because the stock’s performance is dependent upon its market performance, which is guarded by several principles. Rational pricing is very important in the stock market, as this pricing is needed for fixed income securities and bonds. Rational pricing implies such a type of pricing, which represents that the market price of the assets in the stock market is free of any arbitrage pricing. Eugene Fama has been propounded as the father of the theory of ‘efficient market hypothesis’. Fama stated two theories related to the efficient market hypothesis. The first theory was classifying the markets on the basis of three types of efficiency. Fama classified three forms of efficiency which are as follows: Strong form efficiency Semi strong form efficiency Weak form efficiency The strong form efficiency implies that all information related to the firm is incorporated in the price of the stock of the firm. The strong form tests are concerned with whether investors or investor groups have monopolistic access in determining the price of a stock. The semi strong form tests imply the prices are adjusted according to the information available about the firm in their announcements to the public, such as announcements of annual earnings, the stock splits etc. that the firm has witnessed. The weak form efficiency is such a test, where only the historical prices of stocks have been displayed to the public and no other details about the firm is divulged. Fama describes the market efficiency hypothesis to be very simple, which simply points out that the market price of a stock represents all the vital information about the firm. The second concept, which Fama stated with respect to the efficient market hypothesis, was the concept of market efficiency, which can be rejected only with a rejection of the market equilibrium. Thus market efficiency and market equilibrium are correlated. Fama also proposed that the stock market as a whole reflected the information about the individual stock as well as provided a whole viewpoint of the entire stock market. “The efficient market hypothesis is associated with the idea of a ‘random walk’” (Malkiel 2003, p. 3). According to this theory, the hypothesis is that today’s stock price reflects today’s performance of the stock in the market and it is independent of tomorrow’s performance of the stock in the stock market. The prices of stocks are a clear indication of the firm’s performance and thus investments in these stocks are not based upon personal or emotional sentiments. The theory advocates that the stock prices are predictable, as a high price of a stock indicates that the performance of the firm is good. The theory can be practiced in all the three types of market efficiency, which are the strong, semi strong and weak form of market efficiencies. Thus according to this model it is not important to search for undervalued stocks and there is no need for stock predictions. The theory advocates that buying and selling of shares in a stock market is a chance game and it does not require any specific skills or technical analysis, because the markets portray the accurate information about a firm. The theory is in contrast to the theory stated by Warren E. Buffet, who states that technical analysis is needed before buying a stock and it is important to measure the past performance of the stock before making an investment. Buffett’s investment thinking includes applying financial information, not accounting information, concentrating on the time value of money, taking into account the opportunity cost, wealth creation and the alignment of agency troubles and investing on the basis of analysis and information. Comparable to the theory of finance and principle, Buffett uses the ideas of economic value added, intrinsic value, and capital budgeting and corporate governance. Warren Buffett stated that financial statements arranged by accountants conformed to policies that might not sufficiently represent the monetary reality of dealing. Accounting reality was backward-looking, conservative and governed by normally accepted accounting principles. Nevertheless, investment decisions must be based on the economic realism of a business. Under GAAP, intangible assets for instance trademarks, patents, special managerial expertise, and status would be carried at little or no cost, but they might be extremely valuable in financial reality. GAAP calculated consequences in terms of net profit, while, in economic reality, the outcomes of dealing were its flows of cash. Warren Buffett also described economic reality at the stage of business itself, not the marketplace, the financial system or the security. Different to the theory of finance and principle, Buffett utilizes a risk-free discount rate to assess cash flows and differs with the well-organized capital market hypothesis (EMH). The EMH states that stocks are at all times in equilibrium and that it is impossible for a shareholder to consistently strike the market. The EMH supposes that all significant information concerning a stock is impounded in the cost of that stock. Consequently, a stock price is fair in reflecting what is known regarding the business. Under EMH, there are no agreements to be had and attempting to outperform the market will be ineffective. Warren Buffett does not admire the academic theory of capital-market efficiency. He talks about investing in a market, where people consider inefficiency is similar to playing bridge with somebody who has been told that it does not do any good to look at the cards. For him, he utilized a technique developed by Ben Graham, which concentrates on the cost of assets such as net working capital, cash and physical assets to recognize under rated stocks and then invested about those stocks. Ultimately, Warren Buffett customized the method of Ben Graham to focus on important franchises that were unrecognized by the stock market. The stock market appeared to work in a method that permitted all information reflected in past costs to be included into the recent price. In further words, the market efficiently processed the data controlled in past prices. “Fama defined an efficient market as: a market where there are large numbers of rational profit maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants” (Chuvakhin n.d.). In an efficient market, small sales are unlimited. Actually, about 70% of mutual funds state in their prospectus that they will never connect in a short sale. Fascinatingly enough, current empirical confirmation seems to suggest that, while underestimated savings are hard to come by, overrated ones are much more common. The market efficiency has two importances. To some, market efficiency means that there is no methodical method to strike the market. To others, it means that safety costs are rational specifically; reflect only “utilitarian” or “fundamental” characteristics, for instance risk, but not “value-expressive” or “psychological”. Warren Buffett is a cost depositor. Cost depositor search for securities with cost that are unjustifiably low based on their inherent value. When discussing stocks, formative intrinsic value can be a bit complicated, as there is no commonly established method to get this figure. The majority often intrinsic value is estimated by examining an industries essential. Similar to bargain hunters, worth investors look for products that are helpful and of high value but under priced. In additional words, the worth investor looks for stocks that she or he considers are underestimated by the market. Like the bargain hunter, the worth investor tries to discover those things that are precious but not recognized as such by the best part of other customer. Warren Buffett takes this worth investing method to an additional level. Many value shareholders aren’t followers of the efficient market hypothesis, other than they do faith that the market will ultimately start to good-turn those value stocks that were, for a time, underrated. Buffett, on the other hand, doesn’t think in these conditions. He isn’t related to the demand and supply details of the stock market. In the actual fact, he’s not actually concerned with the actions of the stock market at each and every one. “This is the implication this paraphrase of his famous quote: In the short term the market is a popularity contest; in the long term it is a weighing machine” (Warren Buffett’s True Investment Strategy 2011). Securities are papers that simply symbolize awareness or a right in something as well; they are not used or consumed in the same method as traditional customer goods. Government rule of customer goods, efforts to keep customers away from hazardous articles, give the wrong impression about the advertising, or illegal pricing practices. Securities laws, alternatively, effort to ensure that savers have an informed, correct plan of the type of attention they are purchasing and its price. Conclusion: To turn out to be the globe’s second-richest man, Warren E. Buffett working his own investment attitude as well as applying financial reality, not accounting realism; accounting for the chance cost concentrating on the time value of money; focusing on possessions formation; investing on the foundation of analysis and information; and paying attention to the alignment of owners and agents. The position that is taken with respect to the above discussion on the statement that ‘markets are frequently nonsensical’ is wrong and this can be stated by studying Eugene Fama’s ‘efficient market hypothesis theory’, which states that the price of a stock is a sole and strong indicator of a performance of a stock in the stock market and there is no requirement of any other indicator of stock. The efficient market hypothesis has been tested using the three forms of market efficiency. Warren buffet employs the fundamental analysis before picking up a stock. The efficient market hypothesis theory states that market efficiency is tested on the basis of the expected returns and the price of a stock is a good indicator. Thus market performances are not nonsensical. Reference List Buffett, WE. n.d. The Superinvestors of Graham – and – Doddsville. Columbia Business School Magazine. [Online] Available at [Accessed on 08 December, 2011]. Chuvakhin, N. n.d. Efficient Market Hypothesis and Behavioral Finance is a Compromise in Sight? [Online] Available at: [Accessed on 08 December, 2011]. Hagstrom, RG. 1999. The Warren Buffett Portfolio: Mastering the Power of the Focus Investment Strategy. John Wiley & Sons, Inc. [Online] Available at: [Accessed on 08 December, 2011]. Malkiel, BG. 2003. The Efficient Market Hypothesis and Its Critics. Princeton University. [Online] Available at: [Accessed on 08 December, 2011]. Warren Buffett’s True Investment Strategy. 2011. Stocks Commodities. [Online] Available at: [Accessed on 08 December, 2011]. Read More