Question

1. Describe in 100 words or less what it means when we say the capital market is efficient and outline its implications.                                 
2. If the capital market is efficient, does it mean you can expect to do well as the market by randomly picking stocks to form a portfolio? Explain why or why not.                                                                            

Answer 1

"In an efficient market, security price should equal the security’s investment value, where investment value is the discounted value of the security’s future cash flows, as estimated by knowledgeable and capable analysts."

a. Capital markets are financial markets that bring buyers and sellers together to trade stocks, bonds, currencies, and other financial assets.

In an efficient capital market, security prices adjust rapidly to the infusion of new information, and therefore current security prices fully reflect all available information. This is referred to as informational efficiency. For example, when the news about the earthquake in Japan on March 11, 2011 reached the market, the major stock indices in the Asian market fell, and Japanese stock index Nikkei and TOPIX lost heavily. Hence, capital market is efficient when a market is able to efficiently process information.

The idea of market efficiency is very important for investors because it allows them to make more sensible choices.

Implications-

The implication is that investors shouldn't be able to beat the market because all information that could predict performance is already built into the stock price.

If markets are efficient and security prices reflect all currently available information, new information should rapidly be converted into price changes.The news relating to the outbreak of swine flu in Mexico in early 2009, which killed 150 people and spread to nations as far as Spain and New Zealand, created a negative impact on the world financial market, and the benchmark indices of France, Germany and UK fell by 1.9 to 2.54 perent.

The market reacts quickly to various corporate as well as policymakers’ announcements, often in a matter of minutes.Thus, investors cannot expect to earn superior returns by trading on the announcement date.

• Technical Analysis- Technical analysts study records or charts of paststock prices, hoping to find patterns they can exploit to make a profit.The efficient market hypothesis implies that technical analysis is without merit. The past history of prices and trading volume is publicly available at minimal cost. Therefore, any information that was ever available from analyzing past prices has already been reflected in stock prices. As investors compete to exploit their common knowledge of a stock’s price history, they necessarily drive stock prices to levels where expected rates of return are exactly commensurate with risk. At those levels one cannot expect abnormal returns.
• Fundamental Analysis- Fundamental analysts usually start with a study of past earnings and an examination of company's balance sheets.Efficient market hypothesis predicts that most fundamental analysis also is doomed to failure. If the analyst relies on publicly available earnings and industry information, his or her evaluation of the firm’s prospects is not likely to be significantly more accurate than those of rival analysts. Many well-informed, well-financed firms conduct such market research, and in the face of such competition it will be difficult to uncover data not also available to other analysts.

b. Even if capital market is efficient we should consider below points for the selection of stocks (instead of selecting randomly)

Portfolio Management in an Efficient Market-

• The basic principle in portfolio selection is diversification.Even if all stocks are priced fairly, each still poses firm-specific risk that can be eliminated through diversification.Therefore, rational security selection, even in an efficient market, calls for the selection of a well diversified portfolio providing the systematic risk level that the investor wants.
• Rational investment policy also requires that tax considerations be reflected in security choice.high-bracket investors find it advantageous to buy tax-exempt municipal bonds despite their relatively low pretax yields, whereas those same bonds are unattractive to low-tax-bracket or tax-exempt investors.At a more subtle level, high-bracket investors might want to tilt their portfolios in the direction of capital gains as opposed to interest income, because capital gains are taxed less heavily and because the option to defer the realisation of capital gains income is more valuable the higher the current tax bracket.
• Also, rational portfolio management relates to the particular risk profile of the investor.For example, a Toyota executive whose annual bonus depends on Toyota’s profits generally should not invest additional amounts in auto stocks.
• Investors of varying ages also might warrant different portfolio policies with regard to risk bearing.For example, older investors who are essentially living off savings might choose to avoid long-term bonds whose market values fluctuate dramatically with changes in interest rates.In contrast, younger investors might be more inclined toward long-term inflation-indexed bonds.

In conclusion, there is a role for portfolio management even in an efficient market. Investor's
optimal positions will vary according to factors such as age, tax bracket, risk aversion, and
employment.