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Investment management is all about managing finance effectively to derive the maximum benefit from what an individual or group earns. However, it is important to invest in an efficient market where the price of the market gives an unbiased estimation and helps to estimate the true value of investment. It is indeed a debatable fact that market can be deviated with several key concepts. Several researchers have already confirmed in their literature that the “efficiency of the market does not entail that the price of the market be equal to true value at every point of time” (Brown, 2012). Therefore, the price may be less than or greater than actual value. All these deviations, however, are being considered as significant for investor groups. There are a lot of confusions regarding the definition of the market efficiency for inventors group. According to Brigham & Ehrhardt, (2013) “market efficiency is not only about the market that is being considered but also for the group of investor that is covered. It is indeed unlikely that the all markets are efficient to all investors”. However “it is definitely considered that a particular market (for instance, the NSX) is efficient for with respect to the average investor”. This is directly substantial with costs of transactions and tax rates, which bestow advantages on some investors relative to others. Therefore, the implications of market efficiency directly influenced the gaining effectiveness of investors. In a broad perspective, this study will assess the market efficiency and its impacts for managing investment.
The objective of the assignment is to help practitioners and entrepreneurs to understand the field of investments and practice for sound investment decisions making. Following this objectives, key concepts will be presented to provide an application of the theory and practice of investment during the study of the literature. This study is designed to emphasize both theoretical and analytical aspects for taking active investment management decisions based considering the efficient market theory and evidence. The study explores not only the implications of market theories but also highlight shortcomings of the “Efficient Market Hypothesis”. Thus the purpose of the research is to review the status of the EMH with the emphasis on the Baltic stock market.
The phrase “efficient market” was initiated first time in 1965 by E.F Fama who explained that “in an efficient market, on an average, competition will cause the full effects of new information on intrinsic values to be reflected instantaneously in actual prices”. The “efficient market hypothesis, basically called as the “Random Walk Theory”, provide comprehensive view related to the present stock price regarding available details about the organization’s core value and proposed, no other way to generate maximum earnings, (greater than market scenarios), by the means of the information” (He & Xiong, 2013). This is all about the conventional and exciting issues in finance and explains – why is the reason behind the change in price and how those changes impacts on investors. In other words, the implications of the EMH are definitely reflective. “Buying and selling of securities by most of the individuals have been occurred based on assumption that securities they are purchasing would be valued more than the price they are paying right now, while securities that they are selling would worth less than the selling price in future” (Brown & Frank, 2009). As per the overall scenario analysis, if the price of the shares and selling securities are appropriately playing well in the market. Therefore, the EMH is indeed a debatable subject of literature among academics and financial professionals.
The concept of the market of efficiency:
The modern finance is considered the importance of the “efficient market theory”. The current capital market efficiency is fundamentally associated with the efficiency of the costs, while the other markets are often analyzed from the perspective of the efficient allocation of securities Brealey et al., (2012). Therefore, the EMH may be applied to the markets of capital. In the general terms, several researches identified that reflection of the financial information generated from the stock prices would regard the market as inefficient. In that case, the value of the market of the firm changes nearly with the intrinsic value of a company. However several researchers are not considered such changes as consistent and do not control from assets of trading financials. The differences between the awareness of investors and uneven costs of transactions controls the conventional changes in value to be completed and simultaneous reflected in the market place (Malkiel, 2013)
Several researchers have explained efficient market in different ways during the initial conceptualization period. During this period, if markets follow efficiency, changes in assets prices have not been included in algorithms. However, the returns in excessive quantities are considered as a success rather than a result of the perfect predictions. Following this concepts, (Duchin & Sosyura, 2013) further stated that market should be considered as efficient when this has been informed when it was not possible to earn higher than the returns of the market. Based on the theory of efficient market, the subject is built on two pillars: firstly, available information is already included in the values of the stock while performing in the efficient market; secondly investors cannot earn not “risks-weighted excess return”. Therefore, the assessment the price variations is indeed valuable for the investment management and this is the reason many investors significantly spent their time and resources to detect “mispriced stocks” from their portfolios. Many investors are constantly evaluating those securities that are undervalued, with an expectation that they will increase more than others. In other sense, several investment managers believe that an investor opt those securities which will have the potentiality to perform better than the market in the short-term or the long-term basis. In searching of the most potential securities, an investors use variety of forecasting and valuation techniques for taking an appropriate decisions. Obviously, investors have the ability to transform their investors into substantial profits if they exploit the market in a most efficient manner.
It is evident and an understandable fact that entire details about company’s performance are available from the appropriate sources for direct and indirect investors. However, there is a misconception that “fair pricing of all securities in the market reflect the same performance, or that even the probable rising or falling in price is the same for all securities” (Cremers et al., 2016). As per the driven idea from capital markets theory, securities are fundamentally a “function of its risk”. The volatility in securities price reflects in the recent expected future cash flow, which is based on incorporation of market fluctuations and risks related to loan. The present value of expected future cash flow, which is incorporated many elements such as liquidity, market fluctuations and bankruptcy. These prices are rationally based in the market performance, a lot of uncertainties are coming from the rising new information and thus, results price fluctuations which are expected to be unpredictable and random. In the circumstances, stock prices find it rationale to use the “random walk theory” or follow the “Efficient Market Hypothesis”.
Types of different Hypothesis related to Efficient Market:
“Efficient market hypothesis” including “Weak From Efficiency”, “Semi-strong Form Efficiency” and “Strong Form Efficiency”.
The “Weak Form Efficiency” is all about securities are reflected the section of market prices along with available data. In other words, this asserts information containing the historical prices of stocks and there is no use of technical analysis. While the prices of the securities are arguably share the more accessible public details in this form of efficient market. Therefore, markets shared that information which is known by everyone and thus the market named as “Weak” form of efficiency. However, several market practitioners find this form of market as insufficient. This is because it is more about emphasizing on trading volume data and historical stock prices which may have no values due to frequent changes happened in the stock prices. Therefore, the pragmatic “evidence for this form of market efficiency” and it is not aligned with the technical analysis value and thus reduces the price consistency and delivers the weak form of efficiency while performing in the market. Fabozzi et al., (2016) stated “that investors finds it difficult to assess just on believing the available market information such as the stock prices past pattern after considering and analyzing the cost of transactions and of trade securities”.
The “Semi-strong form” considers that securities are comprehensively reflected the price considering the full available information. Thus there is no use of fundamental source of information for analyzing stocks in the due course. It is suggested with the hypothesis that present price comprehensively include every “public available information”. Moreover, the data is reported in the financial statements and contained the past prices financial such as annual reports, “statement of income” and “filings for the Security and Exchange Commission”, announcements of dividends and earning, the competitive positions of financial situation and many others. For instance, in case of analyzing pharmaceutical companies, the relevant information may incorporate information related to the drugs that relieve pain. However, the “semi-strong market efficiency” comes with the assertion that is still not adequate for making a profit using such information which is more or less everybody knows. Nevertheless, the assumption of the hypothesis is far stronger than the “weak-form efficiency” and several financial investors or economists can be able to “comprehend implications of vast financial information” during the time of assessing stock prices for investment.
On the other hand, the “Strong” form asserts investors get full details about the prices of the securities. In other words, the hypothesis not only incorporates the public information but also data related to insiders of the market. According to Bhala et al., (2016), “the basic difference between semi-strong and strong efficiency hypothesis is that the later can be exploited stock information even if trading on information not publicly known at the time”. To make a sound investment portfolio, the research department and the members of the company could not systematically gain informations by purchasing companies shares within a fraction of time. Furthermore, the basis for “strong-form market efficiency” is all about an anticipation of the market in a more unbiased manner and the prices of the stock, therefore, shall definitely be incorporated and analyzed information delivering in a more informative way that the insiders.
Crisis or limitation of Efficient Market:
Investors and several researchers have found disputes in “the Efficient Market Hypothesis” both theoretically and empirically. The imperfections in the market is attributed by the behavioral economists of the financial to cognitive biases combination includes overconfidence, bias relating to information, information bias relating to information and several other conventiona errors done by humans in the processing and reasoning of the information (Fernandez et al. 2016). Due to influence of biasness and several errors in reasoning, investors frequently avoids to stock valuation and buyin growth stocks at expensive rates is preferred. On the other hand, empirical evidence has commonly not supported “strong forms of the Efficient Market Hypothesis”. According to Olasolo et al., (2016), low P/E stocks have greater returns. Implication of the “EMH” for investors:
The “EMH” testing is segregated into dual parts: “tests on prices” and “tests on investment managers and institutions” (Brown & Frank, 2009). Using the historical price behavior in the stock and bond markets by the test of the theory, have infrequently produced evidence in contrast to the null hypothesis of efficiency. It signifies that “the EMH may not relevant for all markets and all times”. Logically, the foundation for these tests is the model of price that represents the “fair” price of the security considering the risk factors. Investors often evaluate the fair stock prices by the model of “Capital Asset Pricing Model” and “Arbitrage Pricing Theory”. The factor that is considered to compensate the investors is the “higher returns generally for accepting the risks factors”. The implication of both the models is significant while determining the expected future return of investment in an asset. The pricing model and the efficiency of the market has been evaluated while tests of the EMH in this framework. In this scenario, much of the debate has focused on whether such violations should be interpreted as inefficiency or simply the inability of investors to appropriately signify the specific risk factors in relation to the market (Brown & Frank, 2009). If investors concentrated solely on the factor of weighted portfolio of the market consisting all traded securities, then such deviations must be useful for assessing the risk premium factor which are generally not captured by the exposure of the market. In this case, the “Arbitrage theory model” could also be defined as “passive exposure” to additional risk factors (Ghouse et al., 2014). Generally, it is suggested by the empirical evidence that investors are compensated for taking systematic risks. Say ,“investing in value vs. growth stocks and volatility risk over the long term”. However, the best tests of trading looking for alpha have signified a broad array of investments which are having profitable potentiality. Furthermore, this provides the limited guidance to investors. On the other hand, the future performances cannot potentially valued in advance due to changing market conditions.
In the second section of the empirical tests of the EMH, the researcher focuses on returns generated by institutions and active managers. The recent theory suggests that some fund managers may have talent and outperform market benchmarks before fees (Crampton, 2015). The investor’s returns tend to be high in the future and the evaluation may be done by using the historical returns of the long period. Numerous researchers suggests there is a methodological problems raised due to results appears inconsistency with the EMH. However, the above mentioned findings will be disappeared if risk is measured correctly.
The potentiality of the stock and its efficiency is depicted by the evidence obtained and consequently the “active management strategies” is of least profitable to the investors. The attempt to overcome the market may not be effective; however, the return generated could be reduced due to the associated costs which are tax, costs of transactions, management and many others (Olasolo et al., 2016). For this reason, investors should follow the “passive investment strategy”. There is no method to overcome the market and this method does not employ such strategy. However, it cannot be concluded that the “portfolio management” does not make significant use of it. The proper diversification and allocation of the assets would help in optimizing the returns. However, the associated costs such as investment costs and taxes must be minimized for achieving the optimized returns. To get the best results, the investment manager must select that portfolio which has the potentiality within the fixed time horizon with identifying certain risks profile. In that case, the risk profile has always been opted out considering age, goals, employment, risk aversion of investors, tax implications and so on.
Technical analysis is based on the previous records. However, EMH believes past outcomes cannot be used to outperform the market. This is the reason EMH hardly used the technical analysis as a means to generate investment returns. On the other hand, Fundamental analysis is all about evaluation of securities by attempting the measure the “intrinsic value” of a stock. Thus, the fundamental analysis approach is broader than technical analysis.
Technical Analysis:
It is important to understand the “recurrent and predictable patterns in stock prices” by technical discussion. Although it is recognized by several technicians that the value of information related to the future economic prospects of the organization, such market information is not necessarily required for developing an efficient trading strategy. It is presumed by many market practitioners that the fundamental change in stock prices can only be identified if the prices of the stock respond slowly. In other words, a market trend can be identified by analyzing the slow moving stocks. This proposition is definitely opposed to the notion of the “Efficient Market”.
According to Dow (2016), the chart lists are only verified by the technical analysts because they records charts regarding the historical stock prices, hoping in search of patterns to exploit the market for making the profit. The changes in market prices are connected by identifying the high and low prices of the stock. The “crossbars” determines the closing prices. In the professional investment terms, this is called a “momentum”. Apart from that several other patterns like “breakaway” or “head and shoulders” are also considered useful for presenting the clear buy and sell signals.
Table 2.0: Different price momentums
By the use of the “Dow Theory”, an investor examines the “long term trends in stock market prices”. The indicators identified and named as the “Dow Jones Industrial Average (DJIA)” and the “Dow Jones Transportation Average” the investors can analyze stocks and their average momentum in a particular market. While using this theory, investors indicate the underlying trends of the prices with the help of the DJIA. On the other hand, DJTA serves as a reject or confirm signal check by this theory of discussion.
The stock prices are affected by three forces by this theory:
The table 2.1 indicates three components of prices considering the movement of the stocks. As per the diagram suggests the “primary trend” is upward. However, the trends for intermediate is lasting for few weeks and declining as well. In other words, it is represented the intraday movements which is not having much value over the stock prices. On the other hand, the Table 2.2 describes the historical trends of the market prices and indentified the market trend. In this case the “the primary trend” is also upward and depicted an evidence that “each market is higher that of the previous peak”. Simultaneously, each low price needs to be higher than the previous low. The identification of “tops” and “bottoms” from the stock pattern is the main concept to identify the underlying trend. In addition, investors must identify “efficient market hypothesis” while discussing the market trend by the use of “Dow Theory”. This theory is considered the “predictably recurring price patterns” (Frahm, 2014). If any pattern is exploited by holding the EMH, then several investors would predict the possibility of attempting to gain. The strategy of trading would be destructed due to the movement of the prices of the stock.
In the recent time, investors also come across new theories which are more advanced than “Dow Theory”. This includes the “Elliott wave theory” and the “Kondratieff wave theory”. The “Elliott wave theory” has been conceptualized by describing a set of wave patterns, like the “Dow Theory”. However, several economists find this model as critical. This is because of the superimposition of the short-term and long-term wave cycles which make the entire interpretation a complicated one for analyzing the price movements. Simultaneously, “Kondratieff wave theory” asserts the empirical tests for evaluating the stock of trends. However, this has been criticized because wave cycles which have been displayed here, last for fifty years. This can provide just “two independent data points per century which is definitely not sufficient information to test the predictive power of the theory” (Willcocks, 2013). The discussion concerning the efficient market implications for the investors, the report are also included another form of theory, named as “Moving Average” method. By this method, the analyst can predict stock prices by taking “average prices over the past several months and used as the indicators of the true value of the stock”. When the value is below the stock price, it can be anticipated that it will fall in the near future. There is another version where the “moving average is taken as indicative of long-term trends”. In this case, “if the trend has been downward and if the present price of stock is below the moving average, then an eventual increase in stock prices above the moving average line might signal of downward trend” (Martinsuo 2013).
The investors are evaluated the market efficiency through another method called the “relative strength approach”. In this case, the market analyst compares the performances of the stock over a present period to the market performance or other stock performance belonging to the same industry. According to Martinsuo (2013), this is the simplest version for assessing the stock prices through the ratio analysis. The indicator of market such as the “S&P 500 index” and if this index ratio over time increases, then the stock becomes strong because the performance of the market is below the stock performance. In this way, investors are evaluated the profit making opportunities over the period of time based on the suitable hypothesis of the market efficiencies.
Fundamental Analysis:
The fundamental analysis are quite appropriate for evaluating the dividend prospects of the organization, anticipated rates for future interest, and risk profile to depict proper stock prices (Dolvin et al., 2012). In other words, the present discounted value of all payments of stock holders are evaluated by this analysis. If the analyst is getting an indication that the value will exceeds the stock price, then this will be recommended for buying the stock. In this study, the investors assess the statement of financial position for examining the past earnings of the firm. Furthermore, it supported with “detailed economic analysis”, “ordinarily including an evaluation of the quality of the organization’s management”,” it within the industry line and lastly, the prospect of the industry as a whole. In connection, the “efficient market hypothesis” anticipates that the analysis done sing the fundamental basis is “doomed to future”. If the analysts believe about the industry information and the availability of earnings, then the appropriate evaluation would not be possible as compare to the other rival analysts (Brigham & Ehrhardt, 2013). There are several “well-informed”, “well-financed” firms who are conducting the research of the market and it will be difficult to disclose all such information for the market analysis in the event of competition (Ortiz et al., 2015). Having unique insights of the investors can be rewarded for the same. However, the type of analysis is considered to be difficult that merely indentifying well-known organizations having future prospects. The investors would be paying higher prices for such corporation if the information is made public and available in the market and the return generated would not be regarded as superior.
Not surprisingly, the “efficient market hypothesis” does not develop any excitement among the managers associated with portfolio. It signifies a great deal of performance of managers considering in need for “undervalued securities” is the best “wasted effort”. Furthermore, it is an inadequate in terms of assessing perfectively diversified portfolio against the investing of a lot of money. This is continually a debatable chapter in relation of the “degree to which security can improve investment performance”. Frankly speaking, the intense competitions among investors create an “efficient market” where the new available information would adjust the price on a fast pace. The “Efficient Markets Hypothesis”, thus, has been refined over the past several decades to reflect information, financing, transactions and the costs of agency. Though the theory of prices have occasionally deviated, the potential active management activities, therefore, needs to be required to multi-assets portfolio.
On the other hand, investors receive returns after compensating the time value of money along with the potential risks. Furthermore, the active security management is a losing proposition while taking the costs of transactions and risk into account. However, no theory can be considered as perfect, the highly acceptable empirical evidence supports thee “efficient market hypothesis”. Thus the discussion of “efficient market’s implication” is indeed a controversial topic for investment management but can be considered as discussing the best description of price movements in the market of securities.
Lastly, this can be stated that the EMH are relevant for the evidence of positive returns in the hedge fund sector where highly paid managers actively trade marketable securities but the duration and quality of the data remain open to controversy and full of doubts.
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