Free «Trying to make Superior Trading Returns» Essay
There has been a lot of economic speak throughout the world recently due to the global recession. This is because as most countries were taken by storm, some very prominent individuals and econometricians for that matter had the storm coming. The debate has ever since the advent of this global recession, drifted from just failures by the governments to put in place correct mechanisms which could positively predict the future fluctuation of prices as well as the growth of the economies.
To fully understand the truth or falsehood of the topic, it is in order understand the definitions and implications of the methods of investment analysis and the theory which generally involves this investment analysis.
First, let us understand what the methods of financial analysis i.e. the fundamental analysis and the technical analysis entail. Fundamental analysis of a business basically involves the analysis of its financial statements, the management and all its competitive advantages, it’s very close as well as far off competitors and the markets. In this analysis investors make decisions regarding the profitability of the company in future. When doing an analysis of stocks, future contracts, or even currencies basing on the fundamental analysis, two approaches can be used. These approaches are bottom up analysis and top down analysis. Usually fundamental analysis is performed on both the historical and present data. This is done with the aim to make financial forecast being the ultimate goal. However, some possible objectives of fundamental analysis includes; conducting a stock valuation in a company and predicting probable evolution of the prices, making some projections on the company’s performance in business, evaluating a company’s management and making some internal business decisions and calculating the company’s credit risk. In simple term this type of analysis is very important in the event of buying shares as a form of long term investment. This because the criteria used for long investment is usually different from the one used when trading in a short term.
Another type of investment analysis is technical analysis. This method involves charting and/or graphing the shares trading history. This is done using different tools such as trendlines, and support and resistance. In this, the demand and supply of a stock can easily be analyzed because all the relevant information needed can be retrieved from the company’s stock charts. Thus technical analysis is basically the study of prices and volumes of stocks. These two variables can combine to form patterns we can identify on the stock chart and also do offer signs of possible movements in the future. Whether this type of investment analysis is or is not enough information to base trading decisions on purely depends on the investment analysts involved.
The Efficient Market Hypothesis (EMH) is a theory developed by Emmanuel Fama in the 1960s. This theory has the assertion that the financial markets are basically ‘informationally’ efficient or in other words, the prices on traded assets such as stocks, bonds, or even property already reflect all known information, and immediately change to reflect this new information. Therefore basing on this theory some critics such as () assert that it is impossible to outperform the market consistently by simply using information that the market already knows about and gives the only exception to this happening as sheer luck.
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About some few years ago, the EMH was very widely accepted by many financial economists such as the founder of this theory Eugene Fama. It was Fama’s very influential article that led to other academicians to believe in this theory and staunchly apply it in all their endeavors as financial analysts. The article, “Efficient Capital Markets” led to most of these elite economists to believe that markets especially the security markets were extremely efficient in the reflection of information about individual stocks and wholesomely about the stock markets. The view that was expected was that when information arises, news spread too fast and is quickly incorporated to the securities without delay. Therefore neither technical analysis, which studies past stock prices so as to predict the future prices nor fundamental analysis, which analyses financial information so as to effectively help the investors select stocks that are considered to be of “less value”, were in a position to enable an investor achieve higher returns than those obtainable by holding a random portfolio selection of individual stocks that have a comparable risk.
(Lo, 2007), came up with a certain joke which is told among academic financial economists. The joke is about an economist who was taking a walk down the street with a companion. As they were walking they came across a USD 100 bill lying idly on the ground, and as the companion stretches so as to reach for the bill, the economist quickly says, “Don’t bother, if it was a genuine USD 100 bill, somebody could have already picked it up.” This very humorous example of an economic logic gone askew can be said to be a very fair rendiotn of the efficient markets hypothesis. It is unmistakably simple to state that the EMH has consequences that can be spread across the board for other academic theories and the business practice as a whole and suprising enough is still resilient to thorough empirical proof and/or refutation. This is because even after all the years of criticisms, economists have not yet come up with a far reaching consensus about whether the markets, especially the financial markets or the stock markets, are indeed inefficient.
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A financial economist (Samuelson, 1965), added his contribution to the EMH through his article titled “Proof that Properly Anticipated Prices Fluctuate Randomly”. In this article he states that in an “informationally efficient” market, if prices are forecasted in the right manner and using the correct variables, then the price changes must indeed be unforecastable on the condition that they fully contain the information and all the expectations of all the participants in the market. After delving into the development of a series of some linear-programming solutions to some spatial pricing models without any doubts or uncertainties, Samuelson eventually ended-up with the idea of the EMH during his developed interest in endeavors revolving around the temporal pricing models on storable commodities that are about to decay.
Contrastively, Fama’s (1965b, 1970) seminal papers were purely based on his personal interests in measuring the properties of stock prices, and also in providing a resolution to the debate between technical analysis and fundamental analysis. Being the first to use the modern digital computer technology in conducting an empirical research in finance, and also the first to coin the term ‘efficient markets’ and at the same time the first to use it. Fama basically operationalized the EMH by the placing of structures on vast information sets that were available to the participants in the market. It was Fama’s attraction to the empirical analysis that led him to follow a very different path than that of Samuelson. This path yielded very significant empirical and methodological contributions such as the many econometric tests of both the single and multi- factor linear asset pricing models, and also a number of empirical irregularities and anomalies in stock, bond, currency and the commodity markets.
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In most cases the efficient market hypothesis is normally associated with the construed idea of ‘random walk’. This is a term which is loosely used in the finance literature to typify a price series in which all subsequent changes in price represents random departures from the previous prices. The sense of this random walk idea is that if flow of information is not hindered and the information is with immediate effect reflected in stock prices, then the following day’s price changes will only reflect that day’s news and will thus be very independent of the any changes in price of the current/present day. However, this news is unpredictable and therefore the resulting changes in prices must in every way be unpredictable and also random. What this means is that prices are considered to fully reflect all the acknowledged information and even the uninformed investors buying diverse portfolio at the prices given by the market will also obtain a rate of return as generous as that achieved by the experts.
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As we have seen the EMH is a proposition that the current prices in stocks fully reflect all the available information about the value of a firm or organization and that there is no way that excess profits can be earned more than the overall market, through the use of this information. The EMH deals with one of the most fundamental and infact very exciting issues in finance i.e. why there are changes in prices in the security markets and how these changes take place. The EMH has important implicaaitons for investors – both non-experts and experts- as well as for the financial managers.
Many investors will always try to recognize securities that are undervalued, and those that are expected to increase in value in future, especially those that will increase more than others. Investors , including the investment managers, have a belief that they can choose securities that will outperform the market. These managers use a variety of forecasting and forecasting techniques to assist them in their decisions concerning investment. It is obvious that any edge that an investor takes is translated to substantial profits.
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The EMH strongly asserts that none of the techniques mentioned above are effective. This is to say that the advantage that is gained does not in any way exceed the transaction and research costs that have been incurred. Therefore according to this theory no one predictably outperform the market.
Evidently, there is not a single theory of economics or finance that has generated such a heated academic debate between its proponents and vehement critics. ‘There is no other proposition in economics’, says Michael Jensen (a renowned economist in a key faculty in the Harvard) ,’that has more solid empirical evidence supporting it than the efficient Market hypothesis’, he concludes. His words goes against the grain of Peter Lynch who says of the hypothesis while investment in Fortunes, April 1995: 7) ‘Efficient markets? That is a bunch of crazy stuff’.
The efficient markets hypothesis (EMH) claims that efforts to profit from predicting price movements are bound to abate. The driving tool that propels behavior in pricing is the arrival of new and relevant information. An efficient market in this regard, is one whose prices adjust relatively in a swift mode and, on the average, divorced from bias, to new information. Consequently, the current prices of securities reveal all the information availed at any particular time of interest. To go rather declarative, there is no data that guarantees the belief that prices are too high or, if you like, low. Security prices have been known to adjust before an investor has the opportunity trade for profits’ sake from a newly availed information.
The summative reason for the presence of an efficient market is the rigorous competition among investors to profiteer from any newly availed information. The know to how to identify over- and-above the underpriced stocks is very indeed inevitable since it allow for investors to buy additional stocks for less than their “true” value and sell others far above their initial worth. As a result, many people will invite a significant duration of time and resources in a bid to detect the advantageous behavior of the market. Inherently, as the competition amongst the analysts soars in their bid to take capitalize on over- and under-valued securities, the eventuality of being capable of getting and exploiting the resulting mispriced securities becomes more and more elusive. In the event of an equilibrium, only a relatively lesser population of analysts will be able to garner significant profit from the detection of the aforementioned mispriced securities—and in fact mostly by fluke. For the widespread and oblivious category of investors, the information analysis payoff would apparently supersede the transaction costs.
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To conclude, fundamental analysis is more objective and predictive of the market behavior than do the technical analysis. This means that technical analysis is product oriented and therefore more effective in analyze markets based on the factual information that has been studied and recorded within the market. The short term nature of technical analysis provides for ample ground for its marriage with fundamental analysis. Fundamental analysis has proven to be very workable with the EMH in terms of giving market growth a sober and reflective analysis.