Stock market efficiency

The hypothesis deals with two of the fundamental questions in finance. The first of them is why there is price change in the market for securities while the second considers how the change actually occurs. Investors involve themselves in identifying the securities that are expected to witness an increase in their value in the future. Moreover, they always try to identify those securities which will witness the maximum increase in their value. They are of the opinion that they have the capability to select only those securities that are expected to perform unexpectedly well in the market and drive the others out. In the process they use different forecasting techniques as well as some valuation methods. The combination of the techniques helps them in their decisions regarding investments. However the hypothesis states that the techniques are not effective and no one has the capability to predict the outperformance of the market. If the investors enjoy any advantage it is supposed not to exceed the incurred cost of transaction and research. Efficient market Hypothesis The theory suggests that it is extremely difficult to profit by predicting the movements in the prices. If in a market, the prices can adjust quickly without being biased to new information, such a market is called efficient markets. The availability of new information can lead to change in prices. The available information is reflected in the current prices of the securities taking a period under consideration. Adjustment in the price level takes place before an investor has sufficient time to trade and accrues profit from new information. Competition among the investors to accrue profit is one of the foremost reasons for the existence of efficient markets. Many are also involved in identifying the stocks that are mispriced. When more and more investment advisors or the market analysts spend time in taking the advantage from the stocks that are either lowly priced or highly priced, the probability of detecting the securities that are mispriced becomes smaller. In a situation characterized by equilibrium, only a small number of analysts will be able to gain from the mis-priced securities because of the chance factor. All investments performing in the market are priced fairly. But it does not imply that they will perform in similar fashion because of the effect of rise or fall in the price level. The capital market theory states that the return expected from a security is a function of the risk. As the nature of the new information is unpredictable, the changes in the prices are expected to be random and the prices of the stocks follow the random walk theory. There are three versions of the hypothesis namely the weak form, the semi-strong form and the strong form of hypothesis. The weak form of efficiency states that the information about the history of prices only are incorporated in the current prices and that is why nobody can detect the securities that are mis-priced and gain from the gain by analyzing the prices of the past. The semi strong form of the hypothesis states that the current price reflects all the information that is available publicly. The last form of hypothesis that is the strong form asserts that all types of information namely public and private are reflected in the current price. The aim of all investors is to accrue maximum gains. The newly generated techniques to predict the movements in price have not been as successful as expected.

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