Implications of the Efficient Market Hypothesis for Security Analysis and Portfolio Management - Essay Example

Implications of the Efficient Market Hypothesis (EMH) for Security Analysis and Portfolio Management Insert (s) Code Date of Submission Implications of the Efficient Market Hypothesis (EMH) for Security Analysis and Portfolio Management Introduction An efficient capital market refers to the market where the security prices adjust quickly to the onset of new information. This information includes public information, past prices such that the activities reflect a zero net profit value. Although EMH had already emerged as a prominent theory by the mid 1960s, it was particularly refined and published by Eugene Farma in his 1970 paper titled “efficient capital markets”. The efficient market hypothesis (EMH) states that prices of assets are efficient in accordance with the information available. With several advisory services for investment, a lot of information and investors, the price adjustment to new information is almost immediately. In addition, an efficient market hypothesis explains the change of prices in a security market and how they occur. Investors and financial managers are the most beneficiaries of the efficient market hypothesis. Fama (1970) particularly argues that the securities markets are extremely important in efficiency of marketing systems. With regard to security analysis is concerned, the efficient market hypothesis openly suggests that neither fundamental analysis nor technical analysis is meaningful, except if the magnitude of funds which can be invested is sufficient enough or when there is a sound originality in the analysis process. The portfolio management process can be described more easily. Proponents of an efficient market can easily change the entire process of professional portfolio management. Although portfolio theory taken alongside the concept of efficient market has implications for the portfolio management, an understanding and knowledge on the relationships which are important between return and risk, the dividing the risk unsystematic and systematic risk, are very important in the portfolio management. Together the security and portfolio market analysis models contribute to the random walk model. Formally, both the security analysis and portfolio management are conditional and marginal probability distributions of independent random marketing variable which are identical in nature. The density function of f and t must therefore be same for an efficient market hypothesis generation. This paper critically analyzes the potential implications of efficient market hypothesis on security analysis and portfolio management. EMH and Technical Analysis of Securities Markets The market security analysis using efficient market hypothesis (EMH) is premised on the argument that in any given market the efficient market price “fully reflect” the available information. This hypothetical postulation regarding market efficiency is a general one hence lacks empirically testable informational implications. To make Eugene Fama’s model tentatively verifiable and testable, the process of price formation portfolio must be specified in a more details. These marketing details are inclusive of portfolio management and security analysis. The presumed possibilities on one hand posit that equilibrium prices or the expected returns on securities are geared and generated in a two parameter business worlds. In addition, the security and portfolio theoretical models and especially the empirical tests of capital market efficiency have not been specified when it comes to the overall market analysis (Jegadeesh, Titman, 2001). Most of the available efficient market hypothesisare based on the economic assumption that the conditions engulfed in the market equilibrium can to some extent be stated in relation to the expected portfolio management and security returns. Accordingly, the conditions on various relevant security information set, the equilibrium expected return on security itself is a functional activity of its risks. On the other hand, there is also a suggestion that in the view of portfolio theories and efficient markets, individual theories can never be priced based on their risks as considered in isolation apart from other securities. Generally, security analysis work is to estimate risk, security return and covariance compared to other securities or market index, in order that the portfolio manager is not provided with a sell, hold or buy recommendation, but with an approximate estimate of distribution of the security returns. The two assumptions of the capital market theory are divisibility and liquidly. This simply means that each of the investors is in a position to change the composition of the portfolio of assets whenever there is a change requirement of the characteristics of the assets. Another fundamental aspect to the concept of efficient markets is the level of sensitivity of capital markets to the information which affects the return-risk characteristics of individual investments. This means that the interest of each investor is to acquire information concerning the securities which are traded in capital markets. Information of such kind enables the investors to be in a position of evaluating the prospects of each of the investment opportunities and hence invest in a portfolio which has the most promising performance. The demand of such information normally will generate the availability of several channels of information channels which is supposed to provide the investor with important knowledge like companies’ balance sheets, stock volumes and prices. According to the efficient market hypothesis, firms as entities which can make productive-investment decisions thus the investors can choose at will among the securities that represent ownership of the business’ internal and external marketing activities. EMH is in most security analysis an assumption based on the business corporation fact that the security prices at any given moment fully reflect all the available information business-wise. The sole role of the capital market in business world is the allocation of ownership based overly on the economy’s capital market. Basically, the efficient market hypothesis (EMH) ideologically represent a marketing structure in which prices review provides accuracy regarding the signals for portfolio management, security analysis and the overall resource allocation. Generally, various models in the capital market can either be used to either help or hinder or help adjustment of prices to information. Firstly, it is easier to determine sufficient conditions necessary for capital market efficiency. For example, putting into consideration a market which has no transaction costs regarding trading securities as well as using all the available information in the determination of the costless availability of convincing power to all the market participants. Lastly, the informational role in relation to business’ current prices and distribution of future prices is solely reliant on the initially available information in the business corporate world. The Role of Portfolio Management in an Efficient Market The performance of a portfolio is precedence to evaluation and analysis of its structure. The utility preference by an investor is a factor which needs consideration in this case. Portfolio management is represented by revision and evaluation strategies. This is due to the re-visit of the previous prices. The models for selection are highly dependent on portfolio management. Lo and Mackinlay (1988) developed a model for asset pricing of capital. The model was developed under assumptions which were termed as rigorous. The theories of existing capital markets do not merge with the real life situation. An assumption is however made that there exists a relation between the theories and the real life situation which warrants a lot of attention. Efficient models of the market represent the capital market. The equilibrium of these two situations is highly correlated. The ideal situation requires that the necessary information to persons that are interested is available. This information includes taxes and costs. The ideal situation is also that the cost of transaction it at its lowest and inflation is zero (Lo and Mackinlay, 1988). The relationship between security and portfolio management is the prices. The prices are important in determining the returns under uncertainty and risk analysis. The theory of capital market is well explained by the asset pricing model in a significant manner. The portfolio manager should understand the significance of the model in analysis of securities. According to the random walk model, in the earlier stage of efficiency markets model, the representative statement that the current price of an investment security fully reflects the available information is assumed to have an implication that the successive price changes. The changes in successive price is in more efficient market cases experienced in successive one-period returns which as quantifiably independent. Passive Investment Strategy Assuming that the funds to be invested are sufficient, then the security analyst will conclude that technical analysis is not worth the trouble. According to Fama and French (1993, p.31), the process of investment should be critically evaluated and the originality is maintained. During passive investment, the role of a portfolio manager is well demonstrated. The manager should be professionally selected and strongly believes in efficient market. He concludes that a risk-free asset does not exist and eliminated lending and borrowing as risk free. If this perspective is taken by a passive investor’s portfolio manager then the investment is likely to fail. The main reason is that the investor will not have the ability to guess the market returns (Fama, 1970). The distinctions between stocks that perform better than those that do not perform better will not be very clear. In addition, efficient market hypothesis assumes that returns or successive changes are identically distributed is made as a conclusion on the implications of efficient market hypothesis for security analysis and portfolio management. Based on the assumptions, the manager will either purchase different varieties of portfolios to hold them tightly or he will sell to only tax losses (Bill, 2010). The latter will apply when the investor is in need of money or is not interested in capital gains. In this case the cost of investment shall have been lower with no exception to taxes, expenses and brokerage. It is now clear why a portfolio manger should understand the efficient market theories. The separation of risks into systematic and non systematic parts is critical for these managers. Liquidity and divisibility are important to an investor in being able to change the nature of their investments in a capital market. Empirical tests for market efficiency The empirical tests of efficient marketing hypothesis are evidences of the three forms of EMH. The first form is the weak form which is based on the random walk theory. It explains the current price based on the previous sequences. An example of inconsistent profitability is the S and P five hundred index of 1980 to 1984 against coin tossing (Fama, French, 1993, p.44). The prices in the intial month were low but the rise was inconsistent but steady with abrupt drops. This form can also be explained by serial correlation of daily stocks which is always at zero. The semi-strong form is the second form of EMH. It is based on the fact that the current price reflects the public information available. This is the same form that was strongly contributed to by Fama(1970). The general information however cannot be used in earning more returns. The semi strong form is more practical in dividend prices, before and after announcements. There have been changes in dividends either an increase or decrease depending on the type off announcement. The strong form of EMH explains that security prices are dependent on all factors not only the information available to the public (Bill, 2010). It shows that any investor or portfolio manager can not earn above market profits. It explains the reason why managers are not able to outperform all the time. Conclusion In conclusion, there exists a close relationship between efficient market hypothesis and portfolio theory. The two theories normally in practice have very vital conceptual effects on the security analysis. Although the Efficient market hypothesis has many limitations and loopholes, it is relevant to the capital market and when related to well, the future outcome can be profitable. To managers of portfolios and securities, the hypothesis is important and can be consulted in major decisions in passive and major investments. The function of the security analysts currently may need to be revised as the theories which have been discussed continue to gain an acceptance by the majority in the financial community. References Bill, R. 2010. The Theory of Stock Market Efficiency: Accomplishments and Limitations. Journal of Applied Corporate Finance, 8(1), pp. 4-18 Fama, E F. 1970. Efficient Capital Markets: a Review of Theory and Empirical Work. The Journal of Finance, 25 (2):pp. 383-417. Fama, E.F., French, K. 1993. Common Risk Factors in the Returns on Stocks and Bonds. Journal of Financial Economics 33 (1): pp.3-56. Jegadeesh, N; Titman, S. 2001. Profitability of Momentum Strategies: An evaluation of alternative explanations. Journal of Finance 56 (2): pp.699-720. Lo, A.W. & Mackinlay, A.1988. Stock Market Prices Do Not Follow Random Walks: Evidence from a Simple Specification Test. The Review of Financial Studies 1(1):pp.41-61. Read More