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Random walk and stocks' return
Historical data suggests stocks' return are subject to a random walk process: it reflects new info that arrives in an unpredictable way
Efficient Market Hypothesis (EMH)
- 1. Weak form: prices reflect historical info
- 2. Semi strong: prices reflect public info
- 3. Strong: all info is reflected, including insider
EMH vs Stock Analysis
- Technical analysis: analyse trends. Usually self-destructive
- Fundamental analysis: use valuation methods to constantly value stock based on expected cash flow
- None of those techniques is likely to be of much value, but at the same time they help spotting anomalies and correcting them.
- For many investors, the best strategy is the passive one
Use impact of info on stock price to assess value of an event (eg: acquisition)
Are markets efficient?
- Magnitude issue: differentiating random noise and tiny degree of inefficiency is likely impossible
- Selection bias: those who know how to beat the mkt don't share their method
- Lucky event issue: even in the case where a theory worked in the past, it could simply be due to randomness
Examples of market anomalies
- Momentum: PF tend to continue their best/worst performance from recent past
- P/E effect: low P/E stocks outperform high ones, even after adjusting for diff in β
- January small firm: small firms usually outperform large ones, especially in January
- Neglected firms effect: tend to show higher return
- Book to market ratio: seem to influence stock price as well
Post Earnings Announcement Price Drift
Prices seem to reflect expected results and react accordingly to announcements, however, the abnormal returns tend to drift further up/downwards after the announcement date. This suggests that people don’t fully reflect the surprises quickly enough in the price.
The Role of PF Management in an Efficient Market
- 1. Necessary for rational diversification
- 2. Require tax consideration
- 3. Security selection is required to address diff investors' risk profile
- 4. Necessary to match investment objective with investors' age