Advanced Investment Theory and Practice - Literature review Example

ADVANCED INVESTMENT THEORY & PRACTICE al Affiliation The Efficient Market Hypothesis Random walk theory is the that the efficient market hypothesis goes by in finance. Professor Eugene Fama developed the theory at the University of Chicago Booth School of business. The theory has close relations with the martingale model. Further studies in researchers found that is hard for investors to outperform the market (Litterman, 2012, p. 17). The efficient market hypothesis proposes that current prices of stock reflect the available information fully in the market. The available information includes the value of a firm and all past and present data about the company. The theory thus strongly supports the idea that there is no way an investor can beat the market and earn excess profits by using the information available to the market. The efficient markets hypothesis deals with the reasons behind the changes in security markets and how the changes come into being. The efficient markets hypothesis has various implications for investors and financial managers. In an active market environment, on the average, competition will bring about the full effects of new data on intrinsic values to be reflected "instantaneously" in real prices (Fama, 1965). The efficient markets hypothesis proposes that it is very hard and difficult for investors to profit from a prediction of future prices of securities. According to the theory, the main force behind the changes in prices of securities in the market is the arrival of new information. If prices quickly adjust without any bias to the new information then the market according to the theory is efficient. The current security prices reflect all the information that is available in the market at any given point in time (Siegel, 2014, p. 31). The reason an efficient market comes into existence is the stiff competition among investors that intend to profit from the arrival of any new information in the market. An investor’s ability to identify both undervalued and overvalued stock prices is precious. It gives them the edge to buy shares at a cheaper price that it actual costs while allowing them to sell assets valued at high rates. The competition between analysts to detect misstated prices in the market reduces their chances of catching any at all. However, by chance, only a small number of the investigators can discover the misstated prices in the market (Rehman and Khidmat, 2013, p. 63). An average investor tends to get back what they pay for in securities. The most vital implication of the efficient markets hypothesis is visible best in the form of a slogan: Trust market prices (Westerlund, Norkute and Narayan, 2015, p. 358). All investments or securities in the market have fair prices. It does not however mean that all investments in the market will perform the similarly. It does not also mean that there are any similarities in the falling and rising of prices of securities in the market (Malkiel, 2003, p. 6). The theory of capital market brings the distinction that reflects the difference in the performance of securities by stating that: the expected return on an investment solely depends on the risks involved in the scheme. The price of an investment or a security in the market reflects the present values of the securities expected future cash flows. The present value includes the volatility of the security, its liquidity and the risk of bankruptcy. The theory of random walk reflects the behavior of prices of the securities in the market. The reasoning behind the argument is that while the prices of a security rationale, the changes in prices of the securities are random and unpredictable. As stated above the behavior of the prices in any given market is due to the arrival of new information. There are two types of market efficiency: operational efficiency and informational efficiency (Tully, 2013, p. 67). Operational efficiency measures how well things function in terms of speed of execution and accuracy. Informational efficiency is the measure of how quick and accurately the market reacts to the arrival of new information. The market is informational very efficient if the security prices adjust quickly and accurately to new information. Versions of the Efficient Markets Hypothesis There are three widely known versions of the efficient markets hypothesis; weak form theory, semi-strong from efficiency and strong form efficiency (Asness, Moskowitz and Pedersen, 2013, p. 940). A. Weak form efficiency One cannot predict future prices of a security by just analyzing prices of the same security from the past. One cannot thus earn excess returns in the future using investment strategies basing them on past or historical share prices or data about the security. The weak form of the efficient market hypothesis states that the current prices of a security fully depends on the information contained in the historical prices of the security. The name weak form efficiency derives its meaning from the availability of information; security prices are the most public as well as the arguably the most readily available information (Westerlund, Norkute and Narayan, 2015, p. 360). The form thus states that one should not be able to gain any profit by using a piece of information that is available to everyone. A technical analysis method is a technique where analysts look for patterns in a sequence of stock prices. Share prices in the weak form of efficient markets hypothesis show no serial dependencies, meaning that they have no patterns to asset prices (Rehman and Khidmat, 2013, p. 69). The empirical evidence for the weak-form efficient market hypothesis is against the value of technical analysis. The weak form efficiency is strong and is entirely consistent. If one considers the transaction costs of analyzing and trading securities, it is very difficult for investors to outperform the market. The availability of the information to everyone makes it challenging for one to have a competitive edge in the market. All on in the market has access to the same information; much is lost in the competition when investors try to beat each other (Siegel, 2014, p. 31). B. Semi-strong form hypothesis The semi-strong efficiency of the efficient markets hypothesis states that security prices fully reflects all publicly available information. Pubic information includes past prices, annual prices, and income statements, filings for the security and exchange commission and investment advisories. It also contains earnings and dividends announcements, macroeconomic expectations, merger announcement plans, competitor’s financial position and so many relevant pieces of information. Just like the weak form efficiency the semi-strong efficiency suggests that one investor should be able to make an excess profit by relying on the public information. However, semi-Strong’s efficiency assumption is stronger than that of the weak form efficiency form. Semi- strong energy market requires that market analysts must exist. It requires analysts who can comprehend the implications of significant financial information but also those who have an in-depth understanding of all macroeconomic factors. Such skills are no available to anyone random. In order for one to test the semi-strong form, adjustments to new information must be of a size that is reasonable and be instantaneous. One must look at the constancy in the downward or the upward changes after the first stage. If there are noticeable adjustments, it will imply that investors interpreted the information in an unfair way rendering the market inefficient. Academic research supports the semi-strong form of the efficient market by looking at various corporate publications that includes stock dividends, cash dividends, and stock splits. Strong form efficiency implies that investors are seldom going to beat the market by analyzing the information presented to the public C. Strong-from efficiency The strong form of market efficiency hypothesis suggests that the current price incorporates all the available information thoroughly, both public and private at times called the inside information. The significant difference between the semi-strong efficiency hypothesis and the strong efficiency hypotheses is that in the semi-strong hypothesis. No investor should be able to gain profits naturally even if they are going by the information does is not yet out to at the time. In other words, the high form of Efficient Market Hypothesis states that a company’s management or staff working in the company is not able to profit from inside information. Even if they decide to buy the shares of the company ten minutes later to go for that which they perceive to be an acquisition that will generate lots of profits. (Considering the company did not publicly announce the information) (Diegnau and Masten, 2014, p. 27). The same case applies to the members of the organization’s research department will not generate any exceeds from the data about the new great discovery they finished half an hour ago. The basis for strong-form market efficiency is that the market anticipates, in a manner not biased, future improvements in stock prices. Therefore, the market incorporates the information and evaluates the stock prices in a more objective and informative way than those that get inside information. Unsurprisingly, however, the empirical research in finance has found evidence that is inconsistent with the high form of the Efficient Market Hypothesis. In order to test the strong form efficiency of efficient market hypothesis, a market should exist in a surrounding where it is impossible for investors to earn excess returns consistently over an extended period. No refutation follows a normal distribution of returns. The refutation is as a result of the prediction of efficiency. Anomalies Empirical evidence does not support the strong forms of the market efficient hypothesis. Low P/E stocks as research shows have greater returns. In accordance with the market portfolio theory, higher returns are as a result of higher betas in the market. The tests show that there are anomalies in the efficient market. Over-reaction and under-reaction According to the efficient markets hypothesis investors are quick to react to new information. The immediate reaction blinds investors to market conditions. They also do not see how the prices behave over time. Others take a lot of time to known that an investment is suitable for them or is bad for them. Such anomalies tend to bring huge losses to investors. Low PE effect-Stocks with low ratios provide higher returns than those with higher PE. Small firm effect- investing in a company with low market capitalization will provide superior risk-adjusted returns. It implies that portfolio managers should give small firms more attention. Neglected firm effect- research shows that security analysts do not pay as much attention to companies that are unlikely portfolio candidates. Such are the companies that offer superior risk-adjusted returns. Portfolio Management Process Portfolio management process starts with an investment policy statement. It includes the objectives and the constraints of the manager. The management process in the case of efficient market hypothesis is focusing on risks that affect the portfolio (Westerlund and Narayan, 2013, p. 1033). They cannot achieve above average returns for their investors because it is unachievable. A portfolio manager aims at  outperforming a given benchmark using any of the investment ideas they have. A portfolio manager should not have the ability to achieve his or he goals according to the market efficiency. Passive Investment Strategy in an Efficient Market Passive investment management does not distinguish attractive from unattractive securities or time markets or the forecast securities. A passive investment strategy involves making investments in broad sections of the market that are called classes or indexes. They make no use of the information presently in the market. Instead, passive investment managers invest in asset based long-turn returns. They base their allocation on historical data of the behaviors of the securities gathered over time. Index investing is another form of passive investment. Here, portfolios base upon security indexes called benchmarks. A community constructs the indexes by sampling various sectors of the market. They reconstruct the indexes mostly after six years by adding or removing some areas depending on the performance. According to the market efficient hypothesis passive investment strategy is a complete waste of time. It is a waste of time because as the efficiency of the market suggests no investor can generate substantial returns in the market. Rather than spending time that increases cost the efficient markets hypothesis suggests that passive investors should aim at reducing the cost of their investments. References Asness, C. S., Moskowitz, T. J. and Pedersen, L. H., 2013. Value and Momentum Everywhere. Journal of Finance, 68(3), 929-985. Diegnau, P. and Masten, L. B., 2014. The Cost of Equity and the Fama-French Three-Factor Model. Value Examiner, 26-28. Litterman, R., 2012. An Experienced View on Markets and Investing. Financial Analysts Journal, 68(6), 15-19. Malkiel, B., 2003. Passive Investment Strategies and Efficient Markets. European Financial Management, 9(1), 1-10 Rehman, M. U. and Khidmat, W. B., 2013. Technical analysis of efficient market hypothesis in a frontier market. Studies in Business & Economics, 8(2), 60-67. Saporito, B., 2014. Do Nothing, Make Money. Time, 184(12), 18. Siegel, J. J., 2014. Is the Market Rational? Kiplingers Personal Finance, 68(2), 31. Tully, S., 2013. What can you learn from Mr. Efficient Markets now? Fortune.Com, 1. Westerlund, J. and Narayan, P., 2013. Testing the Efficient Market Hypothesis in Conditionally Heteroskedastic Futures Markets. Journal of Futures Markets, 33(11), 1024-1045. Westerlund, J., Norkute, M. and Narayan, P. K., 2015. A Factor Analytical Approach to the Efficient Futures Market Hypothesis. Journal of Futures Markets, 35(4), 357-370. Read More