Following Investment Advice - Essay Example

Investment Advice INTRODUCTION The main objective of making any kind of investment is to earn return and this is the reason why investors invest in stocks, projects, assets and different types of securities. However every investor would like to earn more money than the other investor and outperform him. It is perceived, that stock market is an allocator of the resources and in order to perform this role efficiently it is necessary that market is efficient (Jaffe, 2007). However, it is a long debate that either market can be efficient or not. Several theories have been presented by different financial analysts and researchers in this regard. One of the most famous and talked about theories in this regard is of Efficient Market Hypothesis. Because information is available to all the investors who are currently in the stock market therefore everyone would be able to predict the price of the stock and how these prices would vary in future as well. As everyone will be having information therefore there would be no advantage to any investor. An efficient financial market has been defined as the one where prices are able to completely reflect the available information . When it comes to efficiency of stock market or financial market, then it refers to efficiency of allocating resources. In an efficient financial market, funds are directed from lenders to the borrowers in such a way that it is beneficial for the society. According to efficient market hypothesis financial markets an investor cannot earn more returns than the average market returns in the long run as every investor has the information. STOCK MARKET AS AN EFFICIENT ALLOCATOR OF THE RESOURCE Stock market plays the role of allocating financial resources in different sectors. In order to allow the process of efficient allocation of resources and overall growth and development it is necessary for the stock market to be efficient. If the stock market will not be efficient in terms of reflecting all related information, there are high chances that different investors and organisations will take advantage of this situation and will manipulate the market. This in turn will hinder the role of the stock market as efficient allocator of the resources. This in turn makes it necessary to analyse and examine whether it is possible for the market to be efficient or not. EFFICIENT MARKET HYPOTHESIS Efficient market hypothesis is one of the famous financial or investment theories, which tries to explain the general behaviour and trend in the stock market. According to this theory, it is not possible for any investor, either big or large, to beat the market because the stock market is efficient. The share prices of the stocks which are being traded in the market, are decided by incorporating and reflecting all associated information (Quiry, Dallochio, & Vernimmen, 2011). The supporters of the Efficient Market Hypothesis are of the idea that the stocks or shares are always traded at their fair value, which in turn makes it almost impossible for the investors to manipulate the overall stock market by either indulging in the purchase of low priced stocks or selling the high priced stocks. According to this theory, it is not possible for the investors to manipulate or outperform the stock market as the market is efficient in terms of incorporating all relevant information. Efficient market hypothesis is believed to be applicable in the real stock markets by some of the analysts. Many of the financial analysts and economists are of the view that the stock markets are always efficient in terms of reflecting the complete information associated with the different stocks and the overall stock market. This school of thought is of the view that it is possible for the stock market to be efficient, as any new information in the market is passed on very rapidly and hence this information is incorporated in the prices of the stocks. This makes it impossible for the investors and financial analysts to take advantage through the techniques of technical analysis or fundamental analysis. This concept of efficient market hypothesis is directly related with the concept behind the ‘random walk’. However, there is another school of thought which is of the view that it is not possible for the stock markets to be efficient. There are several other factors which directly influence the activities of the investors and the stock markets, which in turn force the stock market to report unusual behaviour and trends. This is supported by the incidences of several stock market crashes. EFFICIENT MARKET: An efficient market is defined as a market in which all the investors have access to the information that influences the stock price. As all the information is available to investors, therefore no one is able to manipulate the market and get better returns on the investment. LEVELS AND TYPES OF MARKET EFFICIENCY: There are three different levels and types of market efficiencies and these levels are as follows: 1. Weak-form efficiency In such a market, it is very difficult for the investors to predict the future price movement of stocks using the past data and the existing prices of stocks reflect all the information of the past prices. 2. Semi-strong efficiency Only investors having access to inside information are able to inside information about the stocks and about the markets are able to take advantage of the market and prices of assets completely reflect publicly available information. 3. Strong-form efficiency In a strong market investors have access to publicly available information as well as inside information and prices of asset reflect both publicly available information and inside information (Tirole, 2006). REASONS FOR BELIEVING MARKET IS EFFICIENT: There have been several analysts and scholars who have claimed that the market is efficient and some of the most important reasons about the fact that market is efficient are as follows: Malkiel (2003) has claimed that it is not valuable for the investors to make use of technical analysis in order to calculate or predict the future of the stock. The main reason for this is that charts and graphs only portray some kind of trends in the market and all the investors can have access to this information and they can calculate and predict the future price of the stock, thus eliminating any high chances of profitability in the long run. So, investors will not be able to earn above average market returns by making use of such technical analysis methods. Predicting and forecasting future changes, trends and fluctuations are not possible for investors using past data of the stock market. According to random walk theory, predicting short run changes in the price of stock is not possible for investors. REASONS FOR BELIEVING MARKET IS NOT EFFICIENT: There are several reasons for believing the market is not efficient that and some of these reasons are as follows: Overconfidence of the investors Investors tend to invest in stock as they have a lot of confidence in the stock of any particular company and according to them the price of that stock would further increase in future. It might be because of the reason that they have some kind of inside information about the company or stock of the company or it might be because of their own gut feeling that investors have a lot of confidence on the stock price and they predict that this would further increase in future. Gambling behaviour and tendency to take Gambles Because many investors would like to take gamble in order to get better return on the investment and this is one of the reasons investors invest in order to get better returns on the investment, they take gambles and invest in different types of stock even stocks in which not many investors invest and they take gamble only to yield better returns. If they had access about all the information, then investors would not be taking such gambles. Unavailability of Information The other reason for believing that the market is not efficient is the fact that information is not available to all the investors as all investors have access to only publicly available information and they tend to take decisions on the basis of limited available information. There are only few investors who have access to inside information of some particular stocks and companies and they tend to dominate the market and make better returns on their investment. CONCLUSION: Investors invest in stock market to get returns on their investment and it is the aim of every investor that they would like to earn more returns on their investment than the others. In order to get better returns on the investment, investors use different techniques and methods to predict the future prices of stock. However, in an efficient market all investors have the access to information that influence the price of the stock thus no one would be able to get better returns and manipulate the market. However, it is not possible. There have been many claims from scholars and researchers around the world that an efficient market is not possible as some investors tend to outperform others. References Tirole, J 2006, The Theory of Corporate Finance, Princeton University Press: USA. Quiry, P, Dallochio, M, & Vernimmen, P 2011, Corporate Finance: Theory and Practice, TJ International Ltd: Great Britain. Jaffe, J 2007, Corporate Finance, Pashupati Printers Pvt Ltd: Delhi. Malkiel, B 2003, A Random Walk Down Wall Street: the Best and Latest Investment Advice Money can Buy, W.W. Norton & Company: New York. Read More