What is the Efficient Market Hypothesis?
The EMH states that an asset’s prices fully reflect some
(or all)* available information. The consequence being
that stocks always trade at their fair value so it is
impossible to consistently pick individual stocks that will
‘beat the market’. It also states that outperformance of
the market is only possible by taking greater (systematic)
risk, which roughly is the equivalent to saying that CAPM
holds.
What is the Security Market line?
And what is the formula?
The Security Market Line (SML) plots the expected rate
of return on an individual security as a function of
systematic (non-diversifiable) risk based on the theory
known as the Capital Asset Pricing Model. More
precisely it says:
Where:
E[rp] = rf + B × ( rm − rf )
rp is the return on a portfolio of stocks
rm is the risk-free rate of return (however defined); and
rf is the market return, or the return on the market.
Problems using statistical analysis in practise for investment analysis
- Correlation does not imply causation. Simply because
two things occur together does not mean either one has
influenced or caused the other. The use of correlations
on their own would typically be considered a shallow
narrative so care should be taken in such instances. - Where correlation exists between two items, any
causation may be the reverse of that proposed. For
example, statistical evidence might show that noise from
roosters and sunrise is highly correlated, but saying
roosters cause sunrise would be erroneous. - There is a danger of omitted variables that can lead to
spurious selection. - Samples might not be as random as they initially
appear. - Co-integration or other econometric problems can exist,
invalidating the underlying statistical assumptions and
invalidating the results.
What factors influence an individual company’s share price?
The
key factors affecting relative demand for individual
shares are investors’ expectations of:
- future dividend payments;
- future capital growth; and
- the risks of the business and thus the uncertainty of
estimates of the above.
Factors that drive expectations for capital and dividend
growth are estimates of profits, free cash flow, and total
enterprise value.
Important General factors to be considered:
- Management ability.
- Quality of products.
- Prospects for market growth.
- Competition.
- Input costs.
- Retained profits.
- History.
What will a fundamental analyst investigate?
- The financial accounts and accounting ratios.
- Dividend and earnings cover.
- Profit variability and growth (by looking at all sources of
revenue and expenditure). - The level of borrowing.
- The level of liquidity.
- Growth in asset values.
- Comparative figures for other similar companies.
What is technical Analysis?
Technical analysis is a method for forecasting the
direction of prices through the study of past market data,
primarily price and volume. Behavioural economics and
quantitative analysis use many of the same tools of
technical analysis. Technical analysis stands in contrast
to the fundamental analysis of security analysis, which
attempts to forecast market prices using financial and
economic data.
Technical analysis employs models and trading rules
based on price and volume transformations, such as the
relative strength index, moving averages, regressions,
inter- market and intra-market price correlations,
business cycles, stock market cycles or, classically,
through recognition of chart patterns. Academics such as
Eugene Fama have said the evidence for technical
analysis is sparse and is inconsistent with the weak form
of the efficient-market hypothesis. However, users of the
technique hold that even if technical analysis cannot
predict the future, it helps to identify trends, tendencies,
and trading opportunities.
It is also relatively easy to apply because price and
volume data are widely available. It is one of the basic of
elements of a trader’s toolkit, especially short- term
traders.
A core principle of technical analysis is that a market’s
price reflects all relevant information impacting that
market. A technical analyst therefore looks at the history
of a security or commodity’s trading pattern rather than
external drivers such as economic, fundamental and
news events. It is believed that price action tends to
repeat itself due to the collective, patterned behaviour of
investors. Hence technical analysis focuses on
identifiable price trends and conditions.
Approaching Technical Analysis
- Investigate whether any of the technical analysis
methodologies and/or combinations of them work in a
particular market by looking at previous price action
(typically using charts) over various time periods and
time frequencies. - Determine the extreme to which the methodologies
work, or nearly work, or work with modifications in each
market. - Use these for market timing and trading – but only in
the context of a bigger overall narrative for investment
analysis.
Behavioural aspects to be managed:
- Fear – thinking too much of the downsides due to a
lack of courage. - Regret and hindsight bias – “the rearview mirror is
always clearer than the
windscreen” (Warren Buffet). - Overconfidence caused by biases.
- Greed – thinking too much about the upside due to
recklessness and/or a lack of
discipline. - Other ego-defence mechanisms.
Main Biases affecting Analysts
- Confirmation bias.
- Gamblers’ fallacy.
- Representation bias.
- Conjunction fallacy.
The main biases in committee decision-making: - Social proof.
Trading actions characteristic of losing money:
- Not respecting stop losses.
- Taking profits prematurely due to fear of losing some or
all of the money made to that point. - Overconfidence leading to belief that the trade could
not go wrong.
*Not thinking through a trade – instead using overly
simplistic logic to justify it. - Trying to call turning points in a move without first
getting confirmation that the market had changed course. - Believing hype from the press.
- Basing a trade on the trader’s narrative – but where the trader’s
narrative did not include the narrative given by the market. - Trading in excess to relieve boredom.
- Executing panic trades.
- Executing ‘fear of missing out’ trades.
- Trading a market where the move in price did not justify the
costs of entering, exiting
and maintaining the trade. - Trading in too large a size, resulting in being psychologically
overwhelmed. - Increased exposure to a losing trade.
- Not acting on new analysis information.
Trading actions characteristic of making money:
