Efficient Market Hypothesis Definition....

Efficient Market Hypothesis Definition

The Efficient Market Hypothesis (EMH) essentially says that all known information about investment securities, such as stocks, is already factored into the prices of those securities. Therefore, assuming this is true, no amount of analysis can give an investor an edge over other investors, collectively known as "the market."

EMH does not require that investors be rational; it says that individual investors will act randomly, but as a whole, the market is always "right." In simple terms, "efficient" implies "normal." For example, an unusual reaction to unusual information is normal. If a crowd suddenly starts running in one direction, it's normal for you to run in that direction as well, even if there isn't a rational reason for doing so.

Three variations

There are three levels, or degrees, of the efficient market hypothesis: weak, semi-strong, and strong.

The weak form assumes that current stock prices reflect all available information, and that past price performance has no relationship with the future. In other words, this form of the hypothesis says that using technical analysis to achieve exceptional returns is impossible.

The semi-strong form says that stock prices have factored in all 

available public information. Because of this, it's impossible to use fundamental analysis

to choose stocks that will beat the market's returns.

Finally, the strong form of the efficient market hypothesis says that all information -- public as well as private -- is incorporated into current stock prices. This form of the efficient market hypothesis essentially assumes a perfect market, and isn't plausible when there are insider trading restrictions.

Criticism on EMH

There are some investors who have consistently beaten the market. As a famous example, Warren Buffett has been highly critical of the efficient market hypothesis. Using his value investing approach and trying to identify a margin of safety in stocks, Buffett has achieved returns that have been far superior to those of the market -- and he's done it steadily over a 50-year period of time.

Behavioral economists are also major critics of the efficient market hypothesis. In a nutshell, the study of behavioral finance is based on the assumption that investors are susceptible to certain biases, such as the belief that past performance is indicative of the future. These biases can lead to mispricings in stocks, according to proponents.

How does EMH effects Investors?

When people talk about market efficiency, they are referring to the degree to which the aggregate decisions of all market participants accurately reflect the value of public companies and their common shares at any given moment in time. This requires determining a company's intrinsic value and constantly updating those valuations as new information becomes known. The faster and more accurate the market is able to price securities, the more efficient it is said to be.

• If a market is efficient, it means that market prices currently and accurately reflect all information available to all interested parties.

• If the above is true, there is no way to systematically "beat" the market and profit from mispricings, since they would never exist.

• An efficient market would benefit passive index investors most.

 

Capital Asset Pricing Model

What is CAPM?

The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between the expected return and risk of investing in a security. It shows that the expected return on a security is equal to the risk-free return plus a risk premium, which is based on the beta of that security. Below is an illustration of the CAPM concept.

The CAPM Formula
Problems with Capital Asset Pricing Model (CAPM)
By extension, once you've calculated the investment's fair value you can then compare it to its market price. If your price estimate is higher than the market's, you could consider the stock a bargain. If your price estimate is lower, you could consider the stock to be overvalued.

Expected Return = Risk-Free Rate + Beta (Market Return – Risk-Free Rate)

For example, if the risk free rate is 5%, the market return is 10%, and the stock’s beta is 2, then the expected return on the stock would be 15%.

15% = 5% + 2 (10% – 5%)

The Capital Asset Pricing Model (CAPM) is based on assumptions. First, the model assumes that a riskier asset will yield a higher return. But this is not necessarily true. A risky asset could decline in value. Second, historical data determines beta. The model assumes this historical data an accurate predictor of future results. But the asset’s future volatility may not necessarily reflect its past volatility.

Why it matters:

CAPM is most often used to determine what the fair price of an investment should be. When you calculate the risky asset's rate of return using CAPM, that rate can then be used to discount the investment's future cash flows to their present value and thus arrive at the investment's fair value.

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Difference Between CML and SML. CML stands for Capital Market Line, and SML stands

 for Security Market Line. ... One of the differences between CML and SML, is how the risk factors are measured. While standard deviation is the measure of risk for CML, Beta coefficient determines the risk factors of the SML. 

The formula for the slope of the CML is (expected return market - risk free rate)/standard dev. market. So we divide it by a measure of risk.

 In the SML the slope is just (expected return market portfolio - risk free rate), without dividing it by some measure of risk.Feb 8, 2008

Roads to Success: Modern Portfolio Theory

Roads to Success: Modern Portfolio Theory: Modern Portfolio Theory: MPT Definition Modern Portfolio Theory (MPT) is an investing model where the investor attempts to take minim...

Modern Portfolio Theory

Modern Portfolio Theory: MPT Definition

Modern Portfolio Theory (MPT) is an investing model where the investor attempts to take minimal level of market risk to capture maximum-level returns for a given portfolio of investments. However, although widely used within the financial industry, there are recent criticisms and variations of style to consider before applying MPT to your own investment portfolio and strategy.

Markowitz, in a 1952 paper published by The Journal of Finance, first proposed the theory as a means to create and construct a portfolio of assets to maximize returns within a given level of risk, or to devise one with a desired, specified and expected level of return with the least amount of risk.

He wanted to eliminate "idiosyncratic risk," or the risk inherent in each investment because of the investment's own unique characteristics.

Markowitz theorized that investors could design a portfolio to maximize returns by accepting a quantifiable amount of risk. In other words, investors could reduce risk by diversifying their assets and asset allocation of their investments using a quantitative method.

With a well-balanced and calculated portfolio, if some of the assets fall due to market conditions, others should rise an equal amount in compensation, according to MPT.

Markowitz demonstrated that, by taking a portfolio as its whole, it was less volatile than the total sum of its parts.

To begin with, Markowitz assumed that most investors are, in their hearts, risk-averse. That means they are more personally comfortable with less risk, and nervous and anxious with increased risk. This also translates into the belief that it is better to not lose money than to find or gain it.

So, given a choice between a higher return possibility with greater risk, and a lower return possibility with less risk, most people will naturally prefer the portfolio with the least risk, even if it means a lower return.

The investor then naturally views a correlation between increased risk and potential higher returns as compensation.

This gets to the heart of Markowitz's theory. Given two portfolios, an investor will naturally prefer one that indicates the highest return possibility with the least risk.

Portfolio Selection, the original title of his ground-breaking theory, was published in March 1952 in and anxious with increased risk. This also translates into the belief that it is better to not lose money than to find or gain it.

So, given a choice between a higher return possibility with greater risk, and a lower return possibility with less risk, most people will naturally prefer the portfolio with the least risk, even if it means a lower return.

The investor then naturally views a correlation between increased risk and potential higher returns as compensation.

This gets to the heart of Markowitz's theory. Given two portfolios, an investor will naturally prefer one that indicates the highest return possibility with the least risk.

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Portfolio Selection, the original title of his ground-breaking theory, was published in March 1952 in The Journal of Finance, published by the American Finance Association. In it, Markowitz argued that portfolios should optimize expected return relative to volatility. He considered volatility could be measured as the variance of return. He suggested also a limit he called the "efficient frontier."

In it, he notes, "the process of selecting a portfolio may be divided into two stages. The first stage starts with observation and experience and ends with beliefs about the future performances of available securities. The second stage starts with relative beliefs about future performances and ends with the choice of portfolio."

"Diversification is both observed and sensible; a rule of behavior which does not imply the superiority of diversification must be rejected both as a hypothesis and as a maxim," he added.

The gist of this selection method is that a portfolio's assets must be selected on the basis of how each asset will impact others as the overall value of the portfolio changes.

Why Is Modern Portfolio Theory Important?

So, when your financial adviser or you decide to have a "diversified portfolio," with assets divided up by percentage in different instruments and sectors -- such as 60% equities (40% large-cap, 20% small-cap), 20% commodities, and 20% fixed income -- that's Modern Portfolio Theory. Also, when you have to manage your own portfolio of investments, whether they be mutual funds or specific securities within your 401K, it helps to know a bit about allocation of your investments versus allocation or calculation of the risks.

Most advisers and even fund managers will do much of the work for you, which is why it is harder to try and do it yourself. For example, in making decisions for investing in a company-provided 401(k), often the manager of the overall portfolio of your choices will provide at the very least the stock or mutual fund's previous return history, and compare it with market returns, to help you, the individual investor, decide how to allocate your investments.

A good broker or financial adviser will ask you what you think is your "risk profile" -- how much risk are you willing to take to get how big a return on your investment? Generally speaking, younger investors can "tolerate" more risk, because they'll have more time to make back money lost in a downturn; older people, especially living on a fixed income have far less risk tolerance, because they might not have the time on earth it may take to recover from a downturn.

Examples of Applying Modern Portfolio Theory

One example of applying MPT relates to a portfolio's expected return. MPT shows that the overall expected return of a portfolio is the weighted average of the expected returns of the individual assets themselves. For example, assume that an investor has a two-asset portfolio worth $1 million. Asset X has an expected return of 5%, and Asset Y has an expected return of 10%. The portfolio has $800,000 in Asset X and $200,000 in Asset Y. Based on these figures, the expected return of the portfolio is

Portfolio expected return = (($800,000 / $1 million) x 5%) + (($200,000 / $1 million) x 10%) = 4% + 2% = 6%

If the investor wants to ratchet up the expected return of the portfolio to 7.5%, all the investor needs to do is shift the appropriate amount of capital from Asset X to Asset Y. In this case, the appropriate weights are 50% in each asset:

Expected return of 7.5% = (50% x 5%) + (50% x 10%) = 2.5% + 5% = 7.5%

This same idea applies to risk. One risk statistic that comes from MPT, known as beta, measures a portfolio's sensitivity to the market's systematic risk, which is the portfolio's vulnerability to broad market events. A beta of one means that the portfolio is exposed to the same amount of systematic risk as the market. Higher betas mean more risk, and lower betas mean less risk. Assume that an investor has a $1 million portfolio invested in the following four assets:

Asset A: Beta of 1, $250,000 invested

Asset B: Beta of 1.6, $250,000 invested

Asset C: Beta of 0.75, $250,000 invested

Asset D: Beta of 0.5, $250,000 invested

The portfolio beta is:

Beta = (25% x 1) + (25% x 1.6) + (25% x 0.75) + (25% x 0.5) = 0.96

Roads to Success: Analysis of Financial Statements

Roads to Success: Analysis of Financial Statements: The analysis of financial statements involves gaining an understanding of the financial situation of an organization by reviewing the o...

Analysis of Financial Statements

The analysis of financial statements involves gaining an understanding of the financial situation of an organization by reviewing the organization’s financial statements. You can use three key financial statements – Income statement, Balance sheet and statement of cash flows. Analysis of these financial statements is often reported to the board of directors and senior management. They use this information as input in their decision-making process. External parties such as regulatory bodies and investors also use this analysis for gaining insight into the organization.

Comparative Statements

Also known as ‘horizontal analysis, are financial statements showing financial position & profitability at different periods of time. These statements give an idea of the enterprise financial position of two or more periods. Comparison of financial statements is possible only when same accounting principles are used in preparing these statements.

Comparative Balance Sheet

The progress of the company can be seen by observing the different assets and liabilities of the firm on different dates to make the comparison of balances from one date to another. To understand the comparative balance sheets. A third column is used to show increases/decrease in figures. The fourth column gives percentages of increases or decreases.

By comparing the balance sheets of different dates, one can observe the following aspects

·         Current financial position and Liquidity position

·         Long-term financial position

·         Profitability of the concern

     It is broken into three parts to include a company’s assets, liabilities, and shareholders' equity. Short-term assets such as cash and accounts receivable can tell a lot about a company’s operational efficiency. Liabilities include its expense arrangements and the debt capital it is paying off. Shareholder’s equity includes details on equity capital investments and retained earnings from periodic net income. The balance sheet must balance with assets minus liabilities equaling shareholder’s equity. The resulting shareholder’s equity is considered a company’s book value. This value is an important performance metric that increases or decreases with the financial activities of a company.

Comparative Income Statement

Traditionally known as trading and profit and loss A/c. Net sales, cost of goods sold, selling expenses, office expenses etc are important components of an income statement. To compare the profitability, particulars of profit & loss are compared with the corresponding figures of previous years individually. To analyze the profitability of the business, the changes in money value and percentage is determined. The income statement is broken into three parts which help to analyze business efficiency at three different points. It begins with revenue and the direct costs associated with revenue to identify gross profit. It then moves to operating profit which subtracts indirect expenses such as marketing costs, general costs, and depreciation. Finally it ends with net profit which deducts interest and taxes. By comparing the profits of different dates, one can observe the following aspects:

·         The increase/decrease in gross profit.

·         The study of operational profits.

·         The increase or decrease in net profit

·         Study of the overall profitability of the business.

Common Size Statements

Common size statements are also known as ‘Vertical analysis’. Financial statements, when read with absolute figures, can be misleading. Therefore, a vertical analysis of financial information is done by considering the percentage form. The balance sheet items are compared:

      to the total assets in terms of percentage by taking the total assets as 100.

·         to the total liabilities in terms of percentage by taking the total liabilities as 100.

Therefore the whole Balance Sheet is converted into percentage form. And such converted Balance Sheet is known as Common-Size Balance Sheet. Similarly profit & loss items are compared:

·         to the total incomes in terms of percentage by taking the total incomes as 100.

·         to the total expenses in terms of percentage by taking the total expenses as 100.

Therefore the whole Profit & loss account is converted into percentage form. And such converted profit & loss account is known as Common-Size Profit & Loss account. As the numbers are brought to a common base, the percentage can be easily compared with the results of corresponding percentages of the previous year or of some other firms.

 Trend Analysis

Also known as the Pyramid Method. Studying the operational results and financial position over a series of years is trend analysis. Calculations of ratios of different items for various periods is done & then compared under this analysis. Whether the enterprise is trending upward or backward, the analysis of the ratios over a period of years is done. By observing this analysis, the sign of good or poor management is detected.

Ratio Analysis

Quantitative analysis of information contained in a company’s financial statements is ratio analysis. It describes the significant relationship which exists between various items of a balance sheet and a statement of profit and loss of a firm. To assess the profitability, solvency, and efficiency of a business, management can go through the technique of ratio analysis. It is an attempt at developing a meaningful relationship between individual items (or group of items) in the balance sheet or profit and loss account.

Below is a breakdown of some of the most common ratio metrics:

Balance sheet: asset turnover, quick ratio, receivables turnover, days to sales, debt to assets, and debt to equity

Income statement: gross profit margin, operating profit margin, net profit margin, tax ratio efficiency, and interest coverage

Cash Flow: Cash and earnings before interest, taxes, depreciation, and amortization (EBITDA). These metrics may be shown on a per share basis.

 Cash Flow Analysis

The actual movement of cash into and out of a business is cash flow analysis. The flow of cash into the business is called the cash inflow. Similarly, the flow of cash out of the firm is called cash outflow. The difference between the inflow and outflow of cash is the net cash flow. Cash flow statement is prepared to project the manner in which the cash has been received and has been utilized during an accounting year. It is an important analytical tool. Analysis of cash flow explains the reason for a change in cash. It helps in assessing the liquidity of the enterprise and in evaluating the operating, investment & financing decisions.

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Roads to Success: Fundamental Analysis for stocks

Roads to Success: Fundamental Analysis for stocks: Fundamental analysis of a stock is used to determine the health of a company. It’s recommended to do a proper fundamental analysis of t...