Efficient Market and Asset Valuation

Many studies indicate that the capital markets are efficient as related to numerous sets of information. At the same time, research has uncovered a substantial instances where the market fails to adjust prices rapidly to public information. What does this mean to individual investors, financial analysts, portfolio managers, and institutions?

 

Efficient Markets and Technical Analysis

The assumptions of technical analysis directly oppose the notion of efficient markets. A basic premise of technical analysis is that stock prices move in trends that persist. Technicians believes that when information comes to the market, it is not immediately available to everyone but is typically disseminated from the informed professional to the aggressive investing public and then to the great bulk of investors. Also, technicians contend that investors do not analyze information immediately. This process takes time. Therefore, they hypothesize that stock prices move to a new equilibrium after the release of new information in a gradual manner, which causes trends in stock price movements that persist. technical analyst believe that they can detect the trend.

The belief in this pattern of price adjustment directly contradicts advocates of the EMH whit security prices adjust to new information very rap- idly. These EMH advocates do riot contend, however, that prices adjust perfectly, which implies a chance of overadjustment or underadjustment. Still, because it is uncertain whether the market will over- or under-adjust at any time, you cannot derive abnormal profits from adjustment errors.

Efficient Markets and Fundamental Analysis

Fundamental analysts believe that, at any time, there is a basic intrinsic value for the aggregate stock market, various industries, or individual securities and on underlying economic factors. Therefore, investors should determine the intrinsic value of an investment asset at a point in time variables that determine value such as current and future earnings or cash flows, interest rates, and risk variables. If the prevailing market price differs from the estimated intrinsic value by enough to cover transaction r,e appropriate action: You buy if the market price is substantially below intrinsic value and do not buy, or you sell, if the market price is above the intrinsic value. An investor who can do a superior job of estimating intrinsic value can consistently make superior market timing (asset allocation) decisions or acquire undervalued securities and generate above-average returns.

Efficient Markets and Portfolio Management

Studies have indicated that the majority of professional money managers cannot beat a buy-and-hold policy on a risk-adjusted basis. One explanation is that money management firms employ both superior and inferior analysts and the gains from the recommendations by the few superior analysts are offset by the costs and the results derived from the recommendations of the inferior analysts.

This raises the question of whether we should manage our portfolio actively or passively? The answer depend on whether the manager has access to superior analysts. A portfolio manager with superior analysts or an investor who believes that he or she has the time and superior investor can manage a portfolio actively by looking for undervalued securities and trading accordingly. In contrast, without access to superior analysts or the time and ability to be a superior investor, you should manage passively and assume that all securities are re properly priced based on their levels of risk.