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JACQUES SCHOLTZ 20822669 ASSIGNMENT 2 Question 4 Discuss the implications of the efficient market hypothesis for investment policy

as it applies to: (i) Technical analysis, and (ii) Fundamental analysis. INTRODUCTION The efficient market hypothesis states that all information regarding the stock price is fully reflected within the stock price. The hypothesis is applied mostly only to companies listed companies. There are different forms of the efficient market hypothesis, the weak form, the semi-strong form and the strong form hypothesis. All three of these forms will be explained as well as their implications regarding investment policy in terms of technical analysis as well as fundamental analysis. CONTENT Technical analysis Technical analysis can be defined as using past data to try and speculate what is going to happen with market prices in the future. Analyst argue that new information enters the market slowly, thus creating a trend in the market and this is mainly because investors dont react to new information as quickly as one would hope. Technical analysts use a variety of instruments to make a decision such to show that the market is predictable and try and earn a profit above the benchmark. The efficient market hypothesis states that past data cannot be used to outperform the market, thus making a profit above the benchmark. The hypothesis thus states that technical analysis has no value for the reason that analysts use past date to try and determine what is going to happen with market prices in the future. The efficient market hypothesis doesnt always adjust perfectly to prices as one would hope, but it is speculated that technical analysis is still of no value because it cannot be said with certainty which way prices are going to move.

Fundamental Analysis Fundamental analysis can be defined as calculating stock prices by looking at earnings and the dividends prospects of a firm, their expectations of interest rates in the future and the risk evaluation of a firm. Certain macroeconomic factors are looked at as well to give an accurate indication of what is going to happen with the stock price. Fundamental analysis is used to make a profit by buying stock that is worth more than what it cost and sell stock for more than it is worth, thus making a significant profit when transaction cost is subtracted. Fundemental analysis is not as easy as it sounds, it requires intensive research such as researching the company, looking at financial statements and evluating them as well looking at past earnings. Identifying a good firm is also simply not enough because if it is a known fact that this company is good the information would be publicly available and the investor will be forced to pay high market prices and will not make a large profit. Analysts should look at companies which is better than anyone else has expected, meaning their stock price doesnt really reflect their potential. A fundamental analyst can make large profits only when he is better than his competitors due to the fact that all information is available. The efficient market hypothesis indicates that fundamental analysis will not work due to the fact all information is reflected in the market price. Thus, fundamental analysis is, like technical analysis, cannot be used to make a profit above the benchmark. Only an investor that is superior and have a unique insight would be able to beat the benchmark, but markets are of such a state already that information is reflected in market prices within minutes, thus making it almost impossibles to make abnormal profits. THE DIFFERENT FORMS OF THE EFFICIENT MARKET HYPOTHESIS Weak form Efficient Market Hypothesis The weak form hypothesis states that all information is reflected in the market price. The Weak form EMH states that there is no correlation between past data and the data in the present, thus past data cannot be used to predict future prices. This nullifies the use of technical analysis and states that no instrument of technical analysis will work. The reason for this is that when information becomes available it is already reflected in the market price, thus the benchmark can be reached but no abnormal profits when transaction costs are taken into account. There are some forms of technical analysis that can provide profits above the benchmark. Due to the fact that price movements are purely based on information that is not included in the market price it can be said that there is no pattern in prices and that the market price is random. Fundamental analysis can thus be used to make a profit out of stock that is overvalued or undervalued and thus beating the benchmark.

Semi-strong Efficient Market Hypothesis The semi-strong EMH refers to the fact that all market prices reflect all public information. The hypothesis further states that an abnormal profit cannot be made based due to the fact that all public information is reflected in the market price. The hypothesis further states that neither technical analysis nor fundamental analysis can be used to earn returns above the market benchmark, thus there is no way to determine if stock prices are overvalued or undervalued. Some argue that some trends can be seen and that a superior analyst can earn returns above the benchmark, although transaction costs and the risk associated will decrease his returns back to the benchmark. Others argue that fundamental analysts who are superior can earn an abnormal profit, but this happens very rarely and is mostly associated with an information leakage that gave them insight into what position the company is going to move into. Strong form Efficient Market Hypothesis In the strong form EMH it is believed that all information, public and private, are reflected in the market price and that it is impossible to earn an abnormal profit. There is hence no monopolistic access to information and prices will adjust rapidly to new information. This cancels out technical analysis and fundamental analysis to be used in order to earn excess returns. In the case of legal barriers preventing private information to become public, strong form EMH is impossible except when the laws are ignored Technical as well as fundamental analysts can try to make abnormal profits, but will only make normal profits in line with the benchmark and in some cases the transaction fees and risk associated with technical analysis will limit the earnings to be less than the benchmark. CONCLUSION The efficient market hyptohesis states that it is not possible to make an abnormal profit due to the fact that all information regarding the market price is reflected within the market price. It should not be possible to make an abnormal profit with technical analysis because of the fact that all past data is reflected within the market price and that the market price adjusts too quickly with new data to make a profit with the price movement. There are some superior analysts who has succeeded in making a profit from the price movement but this was mainly because of information leakage. Fundamental analysis can achieve an abnormal profit in the weak form as well as the semi-strong form, but only when the analyst is superior towards other analysts and when his decision is different and more accurate than those of other investors.

Wthin the strong form neither technical analysis nor fundamental analysis would be succesful to achieve abnormal profits but it is almost impossible to achieve due to the fact that prices adjust too rapidly with new information.

Question 5 Differentiate between the different forms of the Efficient Market Hypothesis (EMH) in terms of the implications for portfolio managers with an active trading approach. INTRODUCTION There are three different forms of the Efficient Market Hypothesis namely the weak form, the semi-strong form and the strong form Efficient Market Hypothesis. These forms each have their different implications for a portfolio managers when the manager uses an active trading approach. There will be looked at what an active trading approach refers to as well as the implications for each form of the Efficient Market Hypothesis. CONTENT Active investment manager An active investment manager refers to a portfolio manager who uses a portfolio strategy and investing in specific investments for the purpose of make a profit higher than the benchmark. An active investment manager will exploit the market by purchasing securities in the market that are undervalued or sell securities that are overvalued in the market. For an active trader to be succesful he should make decisions that differs him from the rest of the other active investment managers and his estimates should be correct. An active investment manager is usually an experienced analyst who swings trade on a day-to-day basis and only focuses on one sector in the market. They are more succesful than other analyst due to the fact that they know how to exploit market opportunities. As mentioned already an active analyst aims to make abnormal profits above the benchmark, however the Efficient Market Hypothesis states that this is actually impossible because it should not be possible to make profits above the benchmark. This statement can be supported by the fact that if you

subtract risk and transaction costs the profit made is either equal to the benchmark or possibly even less. For this reason most investor aim to use a passive investment strategy because it is cheaper.

The weak form Efficient Market Hypothesis The weak form hypothesis is seen as a weak market with a relativie high form of profit potential. The reason for this is that it includes small companies and there are only a few investors that focus on these companies because because there is not much information available on these companies. Transaction costs are also higher with these companies as the risk associated is also higher. Active managers focus only one market segment which they know the best, thus giving the advantage of exploiting market opportunities and making abnormal profits. Technical analysis cannot be used due to the fact that the hypothesis states that there is no correlation between past and future data. An analyst would rather use fundamental analyis to exploit the market and seeing opportunities that other analysts did not see. For an analyst however to make abnormal returns there should be another analyst who makes a loss. If this assumption is not achieved then every analyst would make a profit and no market opportunities would have been exlpoited and no one would make abnormal returns. The semi-strong form Efficient Market Hypothesis The weak form hypothesis refers to all public information that is reflected with the market price. Market prices adjust rapidly to new information thus making it almost impossible to derive abnormal returns. Only investors that have information that is not public yet could make an abnormal profit. This is known as information leakage, but does not happen too often because markets are regulated too closely these days. Active investment managers would look at mid-cap stocks and small-cap stocks due to the fact that they are more liquid. Profit opportunities are also higher with these stocks and to get a competitive advantage over other analysts are easier than it is with large-cap stocks. However risk associated with small and medium caps are higher as well as transaction costs because the portfolio is managed actively. When these costs are taken into account the profit made would be smaller and may even fall beneath the benchmark. Most investors prefer a passive investment strategy because it is cheaper and even though profits are smaller they are more stable. The strong form Efficient Market Hypothesis The strong form hypothesis states that all public and private information is available to everyone and is reflected in the market price. Technical analysis and fundamental analysis cannot be used to make abnormal returns because market prices change to rapidly with new information. For an active investment manager to make abnormal returns out of the strong form hypothesis when there is only looked at large-cap stocks it would seem impossible due

to the fact that all information is reflected in the market price, thus if the assumption holds it is impossible to make abnormal returns within the strong form hypothesis. CONCLUSION An active manager trades on a day-to-day basis and has the goal of making abnormal returns with regard to the benchmark. This proves to be a tough job with regards to the three different forms of the Efficient Market Hypothesis. In the weak form it could be achieved if the superior analyst can see opportunities that other analysts cannot see by using fundamental analysis and scarce cases even technical analysis. In the weak form superior analysts can only make abnormal profits when an information leakage has taken place. In the strong form it seems impossible to make abnormal returns. The transaction costs of an active trading approach is also high which leads investors to rather uses a passive trading strategy.