6.Security Analysis

Question 1

Explain the Efficient Market Theory in and what are major misconceptions about this theory?

Answer 1

In 1953, Maurice Kendall a distinguished statistician of the Royal Statistical Society, London
examined the behaviour of the stock and commodity prices in search of regular cycles instead of
discovering any regular price cycle. He found each series to be “wandering one, almost as if once
a week, the Demon of Chance drew a random number and added it to the current price to
determine next week’s price”.
Prices appeared to follow a random walk implying that successive price changes are independent
of one another. In 1959 two interesting papers supporting the Random Walk Theory were
published. Harry Roberts showed that a series obtained by cumulating random numbers bore
resemblance to a time series of stock prices. In the second, Osborne, an eminent physicist,
examined that the stock price behavior was similar to the movements of very small particles
suspended in a liquid medium. Such movement is referred to as the Brownian motion He found a
remarkable similarly between stock price movements and the Brownian motion.
Inspired by the works of Kendall, Roberts & Osbome, a number of researchers employed
indigenous tests of randomness on stock price behaviour. By and large, these tests have indicated
the Random Walk hypothesis.
Search for Theory: When empirical evidence in favour of Random walk hypothesis seemed
overwhelming, researchers wanted to know about the Economic processes that produced a
Random walk. They concluded that randomness of stock price was a result of efficient market that
led to the following view points:
• Information is freely and instantaneously available to all market participants.
• Keen competition among the market participants more or less ensures that market will
reflect intrinsic values. This means that they will fully impound all available information.
• Price change only response to new information that is unrelated to previous information
and therefore unpredictable.
Misconception about Efficient Market Theory: Though the Efficient Market Theory implies that
market has perfect forecasting abilities, in fact, it merely signifies that prices impound all available
information and as such does not mean that market possesses perfect forecasting abilities.
Although price tends to fluctuate they cannot reflect fair value. This is because the feature is
uncertain and the market springs surprises continually as price reflects the surprises they fluctuate.
Inability of institutional portfolio managers to achieve superior investment performance implies that
they lack competence in an efficient market. It is not possible to achieve superior investment
performance since market efficiency exists due to portfolio mangers doing this job well in a
competitive setting.
The random movement of stock prices suggests that stock market is irrational. Randomness and
irrational are two different things, if investors are rational and competitive, price changes are bound
to be random.