Efficiency of Financial Markets - Coursework Example

A market is efficient with respect to a particular set of information if it is impossible to make abnormal profits by using this set of information to formulate buying and selling decisions.’ Introduction In a capitalist society investors have immense power. Their decisions however are based on the amount and quality of information they posses. Therefore we can say that information sharing plays a central role in today’s world. There are many organizations and set of principles which ensure that information is available to all stakeholders. Stringent laws and severe punishments govern the system of information equality. The efficiency of financial markets is therefore dependent on efficiency of information governance. Market driven Economy The world recession has engulfed the economies of both small and large countries. It is a fact that recession stemmed from the largest economy of the world that is United States of America. It makes one wonder how come most advanced and sophisticated system of the world collapsed. It is just an example of the efficiency of the market economic system where supply and demand are equilibrium. The market system is an advocate of the openness and directness of the interaction between different elements of the economy. The openness of the market reflects the decisions of the elements as performance of the market. Therefore we can say that perception of the investors decide the performance in the market. It has been viewed in the recent economic recession because when investors perceived that the market will perform badly, the indexes did go down following principles of supply and demand. When the investors perceive market wouldn’t perform; the demand for securities is automatically reduced. Thus it has a double effect as compared to other economic entities. In other market entities the supplier and buyers are usually two different market participants with different agendas and motives. It would suggest that usually in other industries if one set of variables affect the supplier they would usually affect the buyer in only a demand-supply relationship (Altvater, 1993). In a financial market however, both the supplier and buyer are the same entities. Therefore if a variable affects the buyer it would definitely affect the supplier as well. A recession therefore would not only drive up the supply of securities but reduce demand as well. Efficient Market In financial terminology an efficient market can be defined as a market where all information is available equally to all stakeholders (Malkiel, 1987). The Efficient Market Hypothesis (EMH) has three different levels. The weak level suggests that prices on all traded securities reflect all the available historical information in the market. The semi strong level of EMH reflects that although markets reflect all publically available information for securities but also readily change according to newly available information. The strong version of EMH goes further to say that security prices in a market even reflect inside and hidden information. EMH is a very important phenomenon for the operational integrity of a financial market. As mentioned above the demand and supply factors are very important in determining price in a financial market as one investor plays both roles (buyer and supplier). Therefore it is imperative for the development of a fair market that information is equally divided between participants (Malkiel, 1987). Equal set of information determines the functionality of the market. If a person in the market could find information about the security that is not available to all other investors than decisions can be made which could allow that particular investor to invest and exploit the market for profit. This information will create an imbalance in the buying and selling decisions (Malkiel, 1987). If there is news about a merger to some investors buying or selling in a market, he can invest in derivatives such as ‘futures’ to reap unfair benefits to gain an edge over the intelligence of other players. Therefore it is considered a very punishable offence to leak information of the company’s future activities to specific investors. The information that can be issued to an investor must be made available to the market as a whole (Malkiel, 1987). The logic given above is the primary basis of the entire financial system and many models that define our financial decision making process. Therefore at every moment the prices of securities reflect all the information available in the market. So about a merger in the newspaper would not affect price of a particular stock, as all the participants would know about the information at the same time. Therefore equal information would create market equilibrium and an efficient market. Keeping in view that markets are efficient and that information and news spread quickly and is integrated into investment decision readily, we assume that no form of analysis would lead to a higher return than expected return of a portfolio of randomly selected stocks. The discussion of both usually used method of analysis has been given below with examples: Technical analysis This branch of financial analysis is model based and uses historical data to predict future prices of stocks and other securities. A is a technical branch of analysis and usually the people who carry out this analysis are called technicians. A technician will use historical prices of securities and figures of volume to analyze the future outcome and make assumptions which would lead to decision making (Kirkpatrick & Dahlquist, 2006). When using technical analysis technicians use methods such as moving average, price graphing, head-shoulder, double top and various other archetypal patterns to predict the future. One of the most important assumptions is that the market is not efficient and an analysis of past information can lead to decision making for profitable investment. The market does not always behave at it is supposed to and will crash because of more behavioral reasons that were explained in the discussion above. This factor is also supported by Malkiel, who says that technical forecasting tools such as pattern analysis are ultimately self-defeating (Malkiel, 1996). The weak or soft form of EMH predicts that technical analysis should not be able to predict prices using historical data but the prices must follow a random trend. Therefore also stating that excess returns cannot be earned from the past analysis of price series (Browning, 2007). The theory which supports weak or soft form of EMH is explained below: Random Walk behavior: The theory of random walk behavior is one key variable which supports the efficient market hypothesis and proves that market is efficient only if everyone has the all the information at the same time. The idea was first put forward by Burton Malkiel in his very famous investment guide ‘A Random Walk down Wall Street’. The theory of ‘Random Walk Behavior’ theory was first introduced by Maurice Kendall in 1953 and suggested that stock price fluctuations are independent of each other as people in a market have access to same information. According to (Burton, 1996) both technical analysis and fundamental analysis are unable to predict the future movement of shares. This phenomenon exists because if the movement of security price is predictable that would mean equal information is not available to investors and abnormal profits in this case would be made using that specific set of information. An investor cannot outperform the market without taking additional risk (Burton, 1996). Therefore according to him the best strategy is a long term holding strategy, which would reap benefits of growth rather than speculation. Therefore it is apparent that theory of random walk questions the applicability of a technical analysis in predicting future stock movements. Fundamental analysis The most famous and widely used analysis is fundamental analysis. This form of analysis as the name suggests does not give a historical perspective but a resource based perspective. The word resource has been used here to describe the fundamental capability or the ability/ inability to generate future streams of income. Moreover fundamental analysis does not rely only on a market perspective of the security but would analyze the driver of the security to determine its price or for that matter predict its future price. The driver is a terminology used to describe the entity on which a security is dependent. The securities such as future are dependent on other securities such as shares and bonds. The shares and bonds floating in a market are in turn dependent on other entities such as companies, governments and so forth. Therefore in fundamental analysis the researcher or analyst would determine the potential in the entity that is a company to determine the price of security. This however is disproved by the efficient market hypothesis which predicts that information is readily available to all investors and profits cannot be made because everyone has the same set of information (Burton, 1987). So, if everyone knows about critical factors such as dividend announcements, stock splits, R&D ventures, financial results than the market will be efficient and no form of fundamental analysis would result in a gain. The semi strong form of EMH also states that no information is readily incorporated into the market decision and therefore no form of analysis fundamental or technical will be able to provide an excess return. A very famous study conducted by Wall Street which provides proof for this semi strong EMH is given below: Investment dartboard: Investment Dartboard is a concept inspired by Burton’s books that suggested a random walk behavior for stocks. In 1988 Wall Street journal started a concept of Investment dartboard (Burton, 1996). This was a method of checking if the returns generated by random selection were lower or greater than big capital markets. According to this process a blind folded person throws darts to select different stocks and the return is than calculated (Burton, 1996). The contest has yielded some very interesting results. The stock market has been proved as efficient because out of a hundred turns the stocks picked by throwing darts won a staggering 39 times (Burton, 1996). Another research conducted through this experiment proved that the best stock analyst could not outperform the Dow Jones index. This means that any person investing passively in the Dow index would have yielded a return which would have been almost equal to the best analyst of the market. It proves that the market is efficient if everyone has the same set of information. If this information base is not shared by everyone in that case an abnormal profit can be made, which renders the use of fundamental analysis and technical analysis as questionable. Conclusion The discussion above has proved that markets are efficient if all available information does not allow any one person to reap unfair profits. The critique on technical analysis and fundamental analysis is therefore justified as research has proved that they do not allow reaping of excess profits over the market. The investment dartboard experiment has therefore proved that market will not give any investor excess profits no even if they use fundamental analysis. This also justifies the statement that abnormal profits can never be made in the market using information that is available to all investors. The first two levels of EMH therefore hold true for all investors even professional analysts which many years experience in their repute and expensive college degrees. The need for effective corporate governance is thus emphasized by arguments presented. The whole system of our financial markets is dependent on equal information distribution to all stakeholders. Therefore inorder to make financial markets efficent (especially in light of recent econmic recession which has shook investor confidence in the financial system) more stringent laws must be passed which ensure equal information distribution to all stakeholders. References Eun, C. Resnick, B. (2004). International Financial Management. Singapore. McGraw-Hill Madura, J. (2007). International Financial Management. New York. Daves, P. Brigham, E. (2005). Intermediate Financial Management. McGraw-Hill. New York. Burton, M (1987). Efficient market hypothesis: The New Palgrave. Burton, M (1996). A Random Walk Down Wall Street. W. W. Norton & Company Browning, E.S. (2007). Reading market tea leaves. The Wall Street Journal. Tucker, I. (2004). Macroeconomics for Today. West Publishing. ISBN: 0324591373 Altvater, E. (1993). The future of Markets. Verso. London Kirkpatrick, C. & Dahlquist, J. (2006). Technical analysis: The complete source for capital market technicians. Pearson. New Jersey. 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