Question

Research documents that firms with high historical returns in the last six months will continue such performance in the next six months, which is termed as momentum in literature. How will you explain this finding if you believe in EMH? What will be your explanation if you believe in behaviour finance? (20 marks)

Answer 1

Momentum and EHM

• The efficient market hypothesis suggests that when new information comes into the market, it is immediately reflected in stock prices and thus neither a technical nor a fundamental analysis can produce excess returns.
• Research relating to behavioural finance, dynamism investment and fundamental common ratios, which is supposed to be contrary to theory, concludes that this does not indicate in the longer run. The efficient market hypothesis is therefore still valid in this opinion.
• Talking about Momentum in literature

Momentum investors base their argument on the following, against the efficient market hypothesis. In a truly efficient market, the short-term serial correlations between stock prices should be zero, but several studies have shown examples of short-term serial correlations that are not zero, thus indicating the possibility of a discoverable pattern.

• Momentum acts as a A complex investment, combination of technical and fundamental analysi arguing that some price trends continue over time against EHM

Thus historical trends in prices sets up a performance momentum in the stock .

Behavioral finance findings that indicate that investors are over-reacting to some events and under-reacting to others. Cites research that shows underreactions are as prevalent as overreactions and that the continuation of post-event misrepresentations is as widespread. That is, according to behavioural finance, what appears to be a pattern may simply be a random occurrence. But occasional anomalies do not violate the efficient market hypothesis; they lose their predictive power when they are discovered and do not hold true in the long run.