Efficient market hypothesis - II
Table of Contents
A. Implications of EMH
Two broad approaches to stock analysis:
-
Technical analysis
- Future prices follow a trend
- Finding patterns in historical prices
- Assumes weak form of EMH is violated
-
Fundamental analysis
- Assumes semi-strong form of EMH is violated
- Forecast future earnings
1. Technical Analysis
Forecase asset prices by studying past market data, primary price and volume.
- Alternative approach to modern portfolio theory
| Aspect | Fundamental analysis | Technical analysis |
|---|---|---|
| Focus | Quantitative & qualitative factors | Price & volume |
| Data | Financial statements | Charts |
| Time | Long term | Short-term |
| Goal | Investing | Trading |
2. Active and Passive Management
Active management – Identifying the “mispriced” securities to beat the market
- Assumes the efficient market hypothesis is false
Passive management – Invest in a well-diversified portfolio without searching for security mispricing.
- Assumes Semi-strong form efficiency
B. Testing Market Efficiency
Event studies – Examine how quickly information integrates into prices around an informational event
- EMH suggests rapid integration of information into prices.
Testing a trading rule – Based on past trading information to attempt to earn abnormal returns
- EMH suggests that such rules will not work