Efficient Market Hypothesis - Essay Example

Study of Efficient Market Hypothesis Table of Contents Introduction 4 Features of Efficient Market Hypothesis (EMH) 4 Critics of Efficient Market Hypothesis 4 Practice 5 Initial Objectives 5 Strategy 5 Effectiveness of Efficient Market Hypothesis 5 Reflection of Share Trading Experience 6 Reflection of Strategy 6 Comparison of Portfolio Performance 7 Conclusion 7 Appendix: Data Analysis 7 Details of transaction 7 Decision making process 8 Research Methodology 8 Changes Made 9 Reflective Journal 9 My Active Portfolio and its Details 9 Comparison of Portfolio Performance with FTSE 250 Index 9 Fundamental versus Technical Analysis and the Rationality of buy/sell Decision 16 Short Analysis and Reflection 18 Reference List 20 Introduction The financial crisis has threatened the economies of various countries including Europe and the United States. It has been suggested by the critics that “Efficient Market Hypothesis” (Abreu and Brunnermeier, 2003) was accountable for the financial crisis. EMH declares that it is not possible to hit the market due to the reason that the efficiency of stock market causes existing stock prices to incorporate as well as reflect all the pertinent information (Malkiel, 2005). EMH does not entail that the prices of asset are always accurate. It does not means that the bubbles in prices of assets are not possible nor does EMH deny that behavioural and environmental features cannot have deep influences on the required risk premiums and rates of returns (Timmermann and Granger, 2004). Features of Efficient Market Hypothesis (EMH) EMH declares that shares are constantly traded at their reasonable value, therefore making it impracticable for the investors to purchase the undervalued shares or sell shares for overstated or inflated prices (Borges, 2010). According to this, it may be impossible for the investors to outperform the entire market through market timing or expert share selection. So, the only means for the investor to receive higher or advanced returns is through buying riskier investments. There are three forms of efficiency i.e. weak-form, strong and semi-strong form of efficiency (Morningstar, 2015). In the efficiency of weak-form, it is not possible to predict the future price by analysing the past prices and the surplus returns cannot be received by employing the investment strategies which is based on the historical data (Gupta and Basu, 2011; Moustafa, 2004). In the semi-strong efficiency, stock prices are adjusted to the publicly accessible new information (Ma, 2004). However, the technical or fundamental analyses are not able to consistently produce surplus returns. In the efficiency of strong-form, share prices reveal all information, private and public and no individual or company can earn surplus returns (Chau and Vayanos, 2008). Critics of Efficient Market Hypothesis The most influential argument against EMH is that the securities markets have frequently experienced excessive bubbles. When the market bubble exploded, internet associated stocks lost almost 90% of their value. The related mispricing of securities which are mortgage-backed had excessive consequences for the financial institutions as well as for the economy of entire world. Critics have deemed these incidents to be evident cases of the market inefficiency. The continuation of bubbles in the prices of assets is regarded as damning proof against EMH (Malkiel, 2003). Practice Initial Objectives The initial objective was to show the performance of the active portfolio by taking the stock of five different companies. The companies which are taken for analysis are Aberdeen Asset Management Plc., EMIS.L Group Plc., Imagination Technologies Group Plc., Tullow Oil Plc. and Vedanta Resources Plc. Second objective was to compare the performance of portfolio of five stocks with the FTSE 250 Index. Strategy A “pound-cost averaging” strategy has been adopted for the trading purpose. It is the practice of purchasing a fixed amount of any investment on normal or regular schedule basis, regardless of their stock price (Fang, 2007). As per this strategy, more shares of company are purchased when their prices are not high and fewer stocks are purchased when their prices are normally high. Among the various stocks, portfolio of five stocks has been chosen by observing their share price, market capitalisation, ratio of price-to earnings (P/E) and their earnings-per-share (EPS). Value investing as well as growth investing strategies was also used (Swenson, 2009). Apart from these, fundamental and technical analysis has also been employed as a part of the strategy. Effectiveness of Efficient Market Hypothesis The EMH upholds that the market prices completely reflect entire available information. It presumes that all the investors take in all accessible information in exactly the similar manner. It states that assets prices are efficient or competent with respect to the available information (Lo, 2005). EMH implies that no strategy of investment which is based on historical or current information produces astonishing large profits. With billions of investors and hundreds of investment services, the amendment of costs or prices to novel information is more or less instantaneous. It implies that the existing stock price totally reflects appropriate news information, though some information is expected and some of them are unexpected. The unanticipated part of the information or news arrives randomly which means that the prices of security follow the random walk theory. Reflection of Share Trading Experience I have taken the shares of five companies for the purpose of trading. The experience of share trading was nice as it helped me to enhance the knowledge on trading strategies. I have employed Yahoo finance to track the records and financial of the companies. Share trading allows having the practice of using the share market. It was not easy to maintain with the shares and being capable to uphold them. Initially, the game was a bit challenging but it allowed me to experience the way of using the share market. It helped to make experiment with various companies and uphold or maintain the money. I have compared the returns of five companies with the FTSE 250 Index and individual movement of their returns were also analysed to know whether the companies are in the sell or buy position. The analysis has also been done to know the growth potential of the companies. Reflection of Strategy I have adopted “pound-cost averaging” strategy because it helps to minimise risks in case of falling price of asset. Investment of fixed sum is made in a company for a fixed period. This strategy minimised the risk of making investment of large sum in single asset at the incorrect time (Fang, 2007). For fundamental analysis, I have employed two tools such as EPS and market capitalisation (Dechow et al, 2001). EPS was taken for the purpose of fundamental analysis because it is a main driver of the share price and reflects the profitability position of the company (Beneish, Lee and Tarpley, 2001). I have also used the strategy of value investing. According to this strategy, current worth of the company was assessed based on their financials. Growth investing strategy has also been used by me, which suggests that stocks are selected by looking at their possibility for progress in the upcoming future (Shefrin, 2011). Further, I have done technical analysis to show the movement of stock of the five companies and also to make selling or buying decision (Lo, Mamaysky and Wang, 2000). A “simple moving average” strategy has been adopted to reflect the movement of share price (James, 2003). If the price of the stock is exceeding the moving average, it presents the bullish sign which means to buy the company stock and when the share price is less than the moving average, it reflects the bearish market which means to sell the stock of the company (Ellis and Parbery, 2005; Kilgallen, 2012). Comparison of Portfolio Performance The portfolio comprises the shares of five companies i.e. Aberdeen Asset Management Plc. (ADN.L), Imagination Technologies Group Plc. (IMG.L), EMIS.L Group Plc., Tullow Oil Plc. (TLW.L) and Vedanta Resources Plc (VED). Three weeks stock price movement of these companies has been captured and then comparison has been done with the FTSE 250 Index stock price. The returns of these companies were calculated individually to observe their performance and then the portfolio has been compared with the return of FTSE 250 Index. Analysis of Simple Moving Average (SMA) of these five companies was also done by taking into consideration the FTSE 250 Index. This analysis was carried out to reflect whether these companies are in the bullish or bearish position and to make judgement on the sell or buy decision. It has been observed that in the second week i.e. on 20th May 2015, ADN.L gave a return of -0.42% and in the third week also it has provided a negative return. EMIS.L has provided a return of -0.77% in the second week and -1.77% in the third week. IMG.L has given the best return i.e. 3.89% in the second week and 6.39% in the third week. In both the weeks it has provided a positive return. TLW.L has also given a negative return of -4.77% and -3.57% in second and third weeks. VED.L has given a return of -7.19% in the second week and -5.79% in the third week. Overall, the average return of IMG.L is highest among the five companies. Conclusion Technical analysis provided the benefits to have the knowledge of stock market as well as to have a deep understanding of bearish and bullish market. The fundamental analysis assisted to be familiar with the tools of fundamental analysis which are considered as the main driver for the profitability position of the company. Further, it helped to understand the benefits of adopting the pound-cost averaging strategy. Appendix: Data Analysis Details of transaction On the basis of the efficient market hypothesis carried out for the portfolio, it was decided that the stocks of ADN.L, TLW.L and VED.L would be sold. While based on the market evaluations purchasing more units of stock of IMG.L and EMIS.L were deemed beneficial as they reflected better performance and bullish trend. Since the other firms were seen to reflect a bearish trend it was perceived by me that selling off the shares of these firm would lead to reduced risks and enhanced returns on the portfolio. Decision making process The decision making process was mainly basing on the technical analysis process, using the moving average technique. This facilitated determining the position of the shares of the companies in the market. The decision making process follows the following steps (Dechow, et al., 2001): Step 1: Returns of all the five companies on the basis of their three weeks performance. Step 2: Analysing the return of FTSE 250 Index. Step 3: Comparing the returns on the portfolio (received from step 1) with that of the FTSE 250 index. IMG.L was seen to be the best performing company based on the evaluations in step 1, 2 and 3. Second best performance was of EMIS.L. Step 4: Employing Fundamental analysis, where the market capitalization of all five firms are evaluated. Fundamental analysis also includes analysing the EPS of all three firms. EMIS.L had the highest EPS while ADN.L had the highest market capitalization. Step 5: Employing technical analysis using the moving average process. IMG.L and EMIS.L were better performing companies based on this evaluation. Step 6: Comparing the results of fundamental and technical analysis and also matching the results with the initial analysis of returns. Accordingly IMG.L and EMIS.L was considered to be better for making investments and the investments from the other firms were withdrawn. Research Methodology The research methodology essentially involves qualitative analysis of the stock prices of the five firms. Qualitative evaluation includes the analysis of returns and employing rational decision making theories. Since the numerical data required for evaluation was collected from Yahoo finance, calculations were not required to be carried out. However the collected data was analysed using graphs. The study is largely descriptive and involves the inductive method of reasoning where conclusions are draws on the basis of the information of collected. Data collection process employed for the research is largely secondary. Various websites were referred to for procuring accurate information in respect of the share values. Also in order to carry out efficient analysis a number of books and journals were referred to. The information from such secondary resources facilitated towards developing the right approach towards stock evaluation and for making investment related decisions (Borges, 2010). Changes Made The pound-cost averaging technique was not extensively employed for decision making. The decision making was carried mainly on the basis of returns on stock, fundamental and technical analysis. There were no changes in the main approaches and the objectives which were set initially. It was ensured that the data collected facilitates meeting the objectives of the paper and suitable decisions in respect of investment can be taken. Reflective Journal The main purpose of this journal is to keep documentation or record of my reflections and thoughts about this topic. I would akin to centre this reflection or evidence on my own opinion about the reality of assessing as well as being assessed. While pursuing this project, I came to know about the efficiency and critics of EMH. It states that it is impossible for the investors to outperform the entire market and somehow I found it correct while carrying out this project. My Active Portfolio and its Details My active portfolio includes the shares of five companies which are traded on London Stock Exchange. ADN.L’s current stock price is 440.20 and it has decreased by 1.43% (Yahoo Finance, 2015a). The current share price of EMIS.L is 965.77 which have increased by 0.29% from the previous day (Yahoo Finance, 2015b). The present share price of IMG.L is 233.70 and has also increased from previous day (Yahoo Finance, 2015c). TLW.L’s current price is 389.30 and has fallen by 1.47% from previous day (Yahoo Finance, 2015d) and that of VED.L’s latest stock price is 571 and has decreased by 2.73% from the previous day (Yahoo Finance, 2015e). Comparison of Portfolio Performance with FTSE 250 Index I have calculated the returns of all the five companies on the basis of their three weeks performance. I have accessed all the data from the Yahoo Finance website and the facts of the companies up to 1st May 2015 is taken for evaluation because the data after this time period has not been uploaded yet in the Yahoo Finance or other authentic website. The return of ADN.L was negative in both the weeks (See Figure 1). Figure 1: Returns of ADN.L Date Open High Low Close Returns 01-06-2015 448.4 448.9 429.9 432.1 -3.25% 25-05-2015 448.5 455.6 445.2 446.6 -0.42% 20-05-2015 437 451 433.9 448.5 Average -1.84% (Source: Author’s Creation) (Source: Author’s Creation) In the second week the return was -0.42% which has further deteriorated in the third week and reached at -3.25%. Figure 2: Returns of EMIS.L Date Open High Low Close Returns 01-06-2015 965 975 940 946 -1.77% 25-05-2015 970.5 973.5 956.5 963 -0.77% 20-05-2015 950 975 932.3 970.5 Average -1.27% (Source: Author’s Creation) (Source: Author’s Creation) Figure 2 shows that the returns from EMIS.L are also negative in both the weeks. It has provided a return of -0.77% in the second week and -1.77% in the third week. However it has performed comparatively well than ADN.L. Figure 3: Returns of IMG.L Date Open High Low Close Returns 01-06-2015 218.2 243.3 217.7 233.2 6.39% 25-05-2015 211 223 209.2 219.2 3.89% 20-05-2015 207.8 217 200.5 211 Average 5.14% (Source: Author’s Creation) (Source: Author’s Creation) Figure 3 indicates that IMG.L has provided a best return among the five companies. The return of this company is positive in both the years and has increased from 3.89% in the second week to 6.39% in the third week. It has also performed well than FTSE 250 Index as the return IMG.L is better than FTSE 250 Index. Figure 4: Returns of TLW.L Date Open High Low Close Returns 01-06-2015 398 400.5 379.96 381 -3.57% 25-05-2015 414.9 414.9 387.2 395.1 -4.77% 20-05-2015 404.8 428.3 397.5 414.9 Average -4.17% (Source: Author’s Creation) (Source: Author’s Creation) TLW.L has provided a return of -4.77% as on 25th May 2015 which has improved to some extent. On 1st May 2015, it has given a return of -3.57%. In general the return of this company is not good. Figure 5: Returns of VED.L Date Open High Low Close Returns 01-06-2015 591 605.19 552.5 553 -5.79% 25-05-2015 632.5 639.6 573.5 587 -7.19% 20-05-2015 654.5 670 631 632.5 Average -6.49% (Source: Author’s Creation) (Source: Author’s Creation) Figure 5 shows that among the five companies of my active portfolio VED.L has given the worst performance. Figure 6: Return of FTSE 250 Index Date Open High Low Close Returns 02-06-2015 18220.3 18263.5 18220.3 18263.5 4.55% 27-04-2015 17784.7 17784.7 17468.3 17468.3 -1.47% 20-04-2015 17603.5 17729.4 17603.5 17729.4 Average 1.54% (Source: Author’s Creation) (Source: Author’s Creation) I have analysed that FTSE 250 Index has provided a good result of 4.55% return in the third week. The return of FTSE 250 Index has improved dramatically from the second week performance. Figure 7: Comparison of the return of my active portfolio with FTSE 250 Index Aberdeen Asset Management -1.84% EMIS -1.27% IMG 5.14% TLW -4.17% VED -6.49% Average of 5 Stocks -1.73% Average of FTSE 250 1.54% (Source: Author’s Creation) Figure 7 shows that the returns of my active portfolio is less than the FTSE 250 Index which reflects that my active portfoli has underperformed. Fundamental versus Technical Analysis and the Rationality of buy/sell Decision For the purpose of fundamental analysis, I have employed various tools like EPS and market capitalisation. The market capitalisation of ADN.L is highest and EMIS.L is lowest among the five companies. EPS of EMIS.L is highest among them which reflect that it is in a better position. I have used Simple Moving Average for the purpose of technical analysis. Returns of all the five companies were compared with FTSE 250 Index and SMA. (Source: Yahoo Finance, 2015a) The price as well as return of ADN.L is less than SMA and FTSE 250 Index which reflects the bearish market and it means to sell the stock of the company. The return of IMG.L is 20.58% and that of SMA and FTSE 250 Index are 7.81% and -0.71%. It presents the bullish sign for IMG.L because its return is greater than both of them, which means to buy the company stock. The return of EMIS.L is 1.18% and that of SMA is -1.80% and FTSE 250 Index is -0.71%. The greater return of EMIS signifies the bullish sign and it represents to buy the stock of EMIS.L. The return of TLW.L is -11.17% and that of SMA is -11.49% which indicates that its return is slightly more than SMA but much poor than FTSE250 Index. It reflects the bearish sign of the market and therefore recommended to sell the stock of the company. VED’s return is less than both of them which reflects the bearish market and therefore means to sell the company’s stock. Short Analysis and Reflection I have gained enough knowledge about how to invest in the company. The technical analysis helped me to understand the concept of bearish and bullish market and assisted to me make the sell or buy decision. I have done my research through the secondary source and mainly taken the help of Yahoo Finance website to track the facts as well as figures of my active portfolio and FTSE 250 Index. My decision making process reflects that I have analysed the market before making the sell or buy decision. I have discovered that employing more strategy or tools would help me to analyse the situation in more appropriate way. Reference List Abreu, D. and Brunnermeier, M.K., 2003. Bubbles and Crashes. Econometrica, 71(1), pp.173-204. Beneish, M. D., Lee, C. M. and Tarpley, R. L., 2001. Contextual fundamental analysis through the prediction of extreme returns. Review of Accounting Studies, 6(2-3), pp.165-189. Borges, M. R., 2010. 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