The efficient market hypothesis

Document Type:Essay

Subject Area:Finance

Document 1

A perfect market refers to a market that bears no preferences to all the market participants such that there shall exist. Free flow and availability of all the essential information regarding the market and perfect mobility of all factors of production with unlimited to the entrance of new participants or exit of existing participants. Thisensures competition is kept high thereby ensuring the actual prices of the market assets are a true reflection of the information available to the market hence eliminating the manipulative elements over the market prices. EMH ensures that the market assets will always trade on equilibrium prices ensuring there exists no over-valuation or under-valuation of assets thereby providing all traders with an equal trade platform that requires no expertized stock selections or market timing to become advantaged.

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Efficient Market Hypothesis Variations The efficient market hypothesis has three variants; ‘strong’, ‘semi-strong’ and ‘weak’ forms. It is as a result of over-reactions or under-reactions in the stock markets. iv. Price shares have also been noted deviating from their fair value on several occasions. For instance in the year 2008, there was experienced a market crash and the famous housing bubble. v. Market Anomalies Below are some of the market anomalies experienced; Post earnings announcement swings Such anomalies are caused as a result of the company’s financial statements announcements. It is caused as the market tries to adjust to the new information. Based on the announcements, the asset prices could either shift upwards or downwards,and this can take approximately two months before equilibriumis attained.

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Contrary, if the perfect market scenario would be inexistent, then the market would only need to adjust instantly. Calendar effects This represents many anomalies that occur throughout the year however in different dates or times. For instance, fundamental analysis would show that a particular stock has been gaining. Therefore investments would be prompted because the prices of this particular stock would be projected to continue having an upward trend in both the short term and medium term. Size effect and neglected firms’ effect Theseare anomalies arising from an outstanding performance of firms that were not even in consideration while valuing the market stock prices. The primary goal for investments diversification is to attain maximum returns possible. There have been numerous publications from various stock specialists with regards to the market trends and future projections.

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Overall, the diversification opportunities are highly available. However, they are limited due to the risk-arbitrage relationships. Global diversification may equally be effective if the returns across countries and asset classes are not highly correlated. The levels of economic growth and pricing of stocks in vary from country to country and as such international diversification can be used as a way of reducing risks. When thinking about International market diversifications, three types of markets canbe chosen from; • Developed marketsareeconomies considered to have stable capital markets and economies which in the long run can be deemed as less risky. Each form of investment exhibits a different profitability level thereby capable of ensuring higher returns can be sustained. Low maintenance High-risk stakes heavily require great servicing since it ought to receive maximum care and caution.

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However, with a diversified portfolio investment can be done with less worry on the level of maintenance and its profitability predictions. Risk reduction Portfolio diversification enables stability in investments. This is because markets will always perform in different mannerisms. According to SERCU and VANPEE (2012), most of the investors with portfolios in Germany, United States, Canada and the United Kingdom have their investments done within the domestic markets. The finance management portfolio theory suggests that investors would always want to diversify into as many international markets as possible as a way of mitigating possible risks associated with domestic investments. The theory, however, has been challenged by the ‘home’ and ‘foreign’ bias. Home bias It involves the ‘investors’ portfolios being concentrated more in domestic markets with very little or no diversification into foreign markets.

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Although the portfolio theory suggests that many investors have diversified their portfolios as a means of reducing investment risks, numerous studies have shown that investors’ portfolios are continually getting more concentrated within the domestic markets contrary to the justifications brought forward by the portfolio theory (Lau, Ng and Zhang, 2010). Some countries would literally create restrictions in form of capital restriction thereby hindering foreigners from investing in their countries. Besides placing restrictions on foreigners, some countries may equally place restrictions on its citizens barring them from investing in foreign markets thereby reslting to a home bias. Home bias may also be as a result of imposition of high costs (trading costs and taxes). High financial costs would mean that the investors would have to part away with too much in form of taxes.

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