With the huge availability of information these days, why aren’t we all high flying city traders? Surely if we can follow a company’s progress continuously we can see their profits coming and buy shares with a click of a mouse! Well unfortunately it’s not that easy, and there are several theories on why it’s more difficult than we first thought.
Fama (1970) developed the Efficient Market Hypothesis, which stated that markets react to information instantly and settle at their efficient level until more news becomes available. Specifically in this blog we will be looking into the EMH with respect to share prices, as there is a wealth of information regarding company’s shares and company news.
Efficient Market Hypothesis (EMH) states two fundamental principles. Firstly, nobody can continually beat the market. Secondly, all prices are based on rational information. So if a company reports good news such as increased dividends or profits then surely the price will rise? And if a company releases reduced profits and starts cutting dividends then prices tumble?
Rio Tinto wrote down 8.9 billion dollars worth of its aluminium stock, over 10% of its total market cap, after it cut its losses on its 2007 Alcan project (The FT 2012). This would be considered bad news by most shareholders, however Rio Tinto shares actually finished up 13p on the day!
(Image: Rio Tinto share price 08-02-2012)
Another strange case was Google reporting a 27% rise in profits in its final quarter. When a company can report profits of $2.7bn and shares still fall by a massive 10% then surely this is great news for shareholders? (BBC 2011) Well apparently not! How does this fit with EMH?
When you dig a little deeper into the EMH, three levels of efficiency appear; weak, semi-strong and strong. Weak form efficiency states that current share prices reflect all past movement, which could be true for Rio Tinto. No matter what the bad news is, if Rio Tinto reported very solid share prices over the past ten years then maybe it’s ok to lose $8.9bn this time, because their track record is pretty good. Or semi –strong efficiency might apply to Google, which uses all past movements and all publicly available information to set the share price. Based on Google’s short history on the market and the public information that is available that shows investors expected higher profits than were reported, then maybe this is why share prices fell.
So if we can’t truly rely on information to correctly balance out market efficiencies, then what’s the alternative? Random walk theory (Kendall, 1953) posits that there is no fixed relationship between share price and time. There is no point looking at past information because it has no influence on the future information and therefore future share price. So maybe we would be better throwing our investment pot randomly over several companies and hope to get lucky? Well if you believe random walk theory then maybe you could apply this to the two cases above?
However, personally I would strongly recommend you don’t start throwing your cash around just yet. There is also behavioural finance theory to take into account. This does not rely on past information but has a much more irrational nature. Because the shares are traded by humans, we can’t simply look at the numbers and make a decision, we are affected by other factors such as regret and confidence, amongst other things. This can create a herd mentality amongst traders and drive prices up or down for no reason, look at Black Monday of 1987. There seems to be no reason for these wild swings in the market but they certainly do happen.
It’s not entirely clear how the stock markets work, or we would be the high flying city traders as mentioned previously, but it is clear EMH, Random Walk and Behavioural Finance theories can all be applied to cases in the market.
But if you think you can beat the market then sign up to Yahoo finance Fantasy Trader and then see which theory you believe...
Click here: Yahoo Trader
References:
http://www.ft.com/cms/s/3/a9596aee-52ff-11e1-8aa1-00144feabdc0.html#axzz1mCXjfJbG
http://www.ft.com/cms/s/2/260cc4d6-9048-11df-ad26-00144feab49a.html#axzz1mCXjfJbG
http://www.bbc.co.uk/news/business-16642925
http://www.ft.com/cms/s/2/260cc4d6-9048-11df-ad26-00144feab49a.html#axzz1mCXjfJbG
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