Stock Market Bubbles, Investing in Stock Markets in Different Countries - Coursework Example

Introduction Over the history of stock markets, investors have tried to make the most of their investment money by identifying a winning strategy that will enable them to outperform the market. Warren Buffet, Jim Salter and Benjamin Graham are legends in the world of investment. Were they smart enough to have established a winning strategy? Or was it pure luck? Or perhaps it was a mixture of both. Is there a winning strategy for the stock market, r is it just a gamble? And if there is one, is it practical and why would I think that this strategy will work for 10, 20, 30, 40 years or even more than that? Well, these are the questions that I will try to answer. I believe that a winning strategy for investing in the stock markets is not impossible, yet it is not that easy. A large number of studies have tried to find ways to outperform the stock market, showing that there were some good strategies. However, these strategies were exploited and therefore, vanished. In this essay I will try to describe a winning strategy which I really believe in and will use in the near future when I have the money. My winning strategy comes from important ideas of the behavioural finance and will be based on stock market bubbles. However, in order to get the most of the bubbles, I will use three strategies when buying stock shares in the beginning of a market bubble. These strategies are firstly, investing in deferent stock markets within different countries. Secondly, combining the best of active and passive investing strategies. And finally, investing in both long-term and short-term by using Contrarian and Momentum strategies. Moreover, in this essay I will draw some final conclusions about this winning strategy. Stock Market Bubbles A market bubble can be defined as trading at prices higher than the fundamental value of an asset. In my winning strategy I will use market bubbles in my favour and try to get the most out of the bubbles. The main technique of my strategy is to buy at the beginning of the bubble and sell at the peak of it. However, defining the beginning and the peak of a bubble is not an easy task. In fact, it is extremely difficult and almost impossible to determine. Nevertheless, my strategy will be flexible regarding this issue. The strategy suggests that buying at any time in the end of a bubble or in the beginning of a new one will be acceptable. The same level of flexibility will apply when selling. This means that the selling process can occur anywhere between after the peak of the bubble or before the peak of a bubble. I will be using the Price Earnings (PE) ratio of the index as a guideline for the timing of buying or selling. My strategy will be neither entirely passive nor aggressively active, but it will be somewhere in the middle. I will use the PE ratio that was proposed by Benjamin Graham and David Dodd (1934) and it will be adjusted to inflation. My strategy suggests buying when the PE ratio of the stock market index is at any point lower than 12 and selling at around 24. This first part of my strategy gives guidance on when to buy, but does it tell the investor what to buy? The next part of my strategy will answer that question. At this point there will be two approaches. The passive approaches i.e. invest in tracker funds or the active one. My strategy suggests a mixture of both and for that I will use three techniques in order to get the most of the market bubbles. They are firstly, investing in deferent stock markets within different countries. Secondly, combining the best of active and passive investing strategies. And finally, investing in both long-term and short-term by using Contrarian and Momentum strategies. Investing in different stock markets and in different countries Recently, investors realized that some part of the risk can be eliminated by diversifying a cross between different countries (Mishkin & Eakins 2006; p.288). A geographical diversification will give many advantages, such as the reduction of risk currency changes that will affect on share prices. Investing in developed stock markets has many advantages. For instance, they are mature and have been existing for a long period of time and they are considered to be efficient, which means that stock prices represent the current available information. Farma (1970) defined an efficient financial market as the one in which securities always fully reflect the available information and suggested three sets of the Efficient Market Hypothesis which are the weak form, the semi-strong form and the strong form. However, according to Hines (2002; p.56), “it is clear that the theory of EMH and the claims of efficient valuation of securities through the utilization of information is somewhat flawed”. Nevertheless, the issue of the efficiency of the market could be useful for understanding the price movements and the information in the stock market. Even though, emerging stock markets is inefficient and risky. The expected returns are much higher than developed markets (Farma and French 1997) and according to hook (1999; p.447), “many foreign economies, particularly in those developing countries known as emerging markets are expanding faster than the US economy”. Combining the best of passive and Active strategies My winning strategy suggests using Passive fund management, which involves a buy and hold strategy for the long-term, especially in the efficient stock markets. Thus, Passive portfolio management is consistent with two conditions. Being satisfied in the securities market firstly, efficiency so that there will be no miss valued securities and secondly, homogeneity of expectations of the risks and returns on securities, so hence there will be a consensus view concerning the market portfolio, the capital market and security market liens (Blake 200; p.512). But investors should not try to beat the market average. However, fund managers should try to build portfolios which are close to the market average. Moreover, in order to build or rebalance the portfolio, Passive strategy does not need to buy or sell every time. Expensive analysts and costly data bases because the market is efficient and investors are rational enough. Therefore, Passive strategy involves less transaction and research costs than an active management strategy. My winning strategy suggests that the portfolio in emerging markets should be managed by Active portfolio management. Thus, Active approach involves frequent adjustment to the portfolio and active managers do not believe that securities markets are continually efficient (Blake 2000; p.512). Besides, fund managers should try to identify the sectors of market or individual shares that are underpriced. So, the portfolio should perform better and beat the market. Also, in such inefficient market it is believed that the investors’ expectations of risks and returns on stocks would be better than the rest of the market and the portfolio could generate excess return because there are many companies which are disvalued. Since emerging markets are insufficient, security prices do not always reflect the available information and most investors are irrational. Therefore, the essence of technical analysis is the search of recurrent and predictable patterns in stock price and the use of historical prices and trading volumes date in order to predict future stock prices (Tisiolas 2004; p.10). Investing in both long-term and short-term It is important not to only understand the risks involved, but also to set investment objectives and timeframe, therefore in my winning strategy the main objective of this stock investment is to increase the wealth over the long-term by applying Contrarian strategy, and also there will be transactions on the short-term when there is an opportunity to sell or buy in an opportunity prices by applying Momentum strategies. Contrarian strategy is to buy in past loser stocks (that have low value measures such as earnings, dividends , historical prices and book assets) and sell past winners and then stock prices will reverse over three to five years. This strategy is an extension of the overreaction. Investors overreact to past prices and undervalue those stocks which perform unfavourable in the past. This will likely to lead the price raise at the beginning. However, following by information spared out, stock prices will reverse back to its mean. Shiller (1987) indicated that over horizons of three to five years, returns seem to be negatively auto correlated that volatility of price will be gradually corrected and the overreaction might occur due to nose trader influence. However, there is a time lag after the good or bad news is reported within a short term over 3 to 12 months, so that past winners continue to outperform past losers for this period of time as the overreaction is realized by the market (Miles; 2003). Therefore, Momentum strategy is suggested in this short term that buys stocks with high returns over the previous 3 to 12 months and sells stocks with poor returns over the same period of time. So, the idea is to take advantage momentum the prices of winners will continue to inflate for a while, therefore buy them and when winners turn into losers, sell them instead of waiting for the prices to recover (Hirano, 2001; p.22). Besides, under Momentum strategy, investors should be careful with Seasonality affect, particularly that negative return which occurs in January. There are many reasons that cause this effect, for instance, the investor’s consideration about tax problems . The last day of the year loser stocks trade on bid price but winner stocks trade on ask price. However, Liao (2004; p.60) claimed that investors may attempt to realize the loss by selling losers at the end of the year. However, these stocks are counteracted by the selling force in the next January. Hence, the effect of momentum strategy is neutralized. Why would this be a successful strategy? Investment in stock markets involves many uncertainties, predictions and emotional judgment. I think that my winning strategy will work and will be suitable for everyone now and in the future. This is because my winning strategy is constructed on a solid base. My winning strategy is based on both behavioural and modern finance. Thus many issues in stock markets have been interpreted by modern finance. However, anomalies have occurred and therefore behavioural finance came along to provide an understanding to these anomalies. Furthermore, academic literature and empirical evinces. Thus, although academic researchers are generally testing theories, these tests were applied in real stock markets. Conclusion Investors have been trying to make strategies that outperform the market but they have failed. However, a considerable research implies that the market might be predictable in some incompetent circumstances. In my opinion, constructing a winning strategy is very difficult. Although I have faith in my strategy, I will not bet everything on it. Bibliography Blake, D. (2000). Financial Market Analysis (2 ed.). Chichester: John Whiley & Sons Ltd. Farma, E. (1970). Efficient Capital Markets a review of theory and epirical work. Journal of Finance (25), 338-417. Farma, E. (1997). Market Efficiency- long-term retuns and behaivural finance. Journal of Financial Economics , 79, 283-306. Hines, S. (2002). Efficiency Market Hypothesis, are stock markets really efficient? Portsmouth: University of Portsmouth . Hirano, T. (2001). Testing an investment strategy based on behavioural finance- Do value stocks outperform grouth stocks over the long-term. Portsmouth: University of Portsmouth. Hooke, J. (1999). Security Analysis On Wall Street. Financial Markets an Introduction . Liao, M. (2004). What is the effective investment Strategies within the Electronic and Technology Sector of the UK stock Market. Dissertation . Miles, J. (2003). Analysis of Contrarian Investment Strategies withen the Electronic and Technology Sector of the UK stock Market. Dissertation . Shiller, R. (1987). Fashion, Fraud and Bubbles in financial Markets. In j. Coffee. Tsiolar, A. (2004). Testing the Market Efficiency of the Athens Stock Exchange. Dissertation . Read More