Efficient market hypothesis - II

Table of Contents

A. Implications of EMH

Two broad approaches to stock analysis:

  1. Technical analysis

    • Future prices follow a trend
    • Finding patterns in historical prices
    • Assumes weak form of EMH is violated
  2. 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