Essay Sample on Maximizing Market Efficiency: Assessing Stock Returns & Effects of Information

Introduction

For long term assets, any aberrations in the stock returns are based on the level at which the assets react to any changes that take place prior and after an assessment. Market efficiency is how the assets could be predicted and the expected change due to the acquired information. The efficiency of the market is based on the way and rate at which any information such as good sales reports, reaches the shareholders. In the market, leaking of information is crucial in that anyone with a prior understanding can make a better guess of how the shares will behave.

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Behavioural Finance

On the other hand, Behavioral finance focuses on understanding how investors tend to behave during their decision-making process. It gives an insight into some of the factors that these investors put into consideration and how they understand the basics of their transactions and decisions (Titan 441). An emphasis is also given to how the decisions are influenced and who is more influential to the investor when they make the decisions.

By closely monitoring this process, Psychologists have discovered a trend in the way the business people behave when deciding on which investment to make. At the beginning of the 20th century, studies revealed that these trends are closely related to the way the investor undertakes their lives and how they behave (Titan 448). By understanding that every successful year does not necessarily mean a better following year but rather a possibility of an opposite, Behavioral Finance then paved the way for the development of better decision-making the process.

Fund Management

Fund management can be said to be either active or passive. Active Fund Management is the situation where the managers, investor or advisors are actively participating in making decisions on how the investments should be done; while in Passive Fund Management, the investment is guided by the behaviour of the Market Index. The decisions in this level, even though not wholly passive, are made according to how the value of the invested asset is changing.

Active funds open a unique gateway to outdo the market index as it is independent of the changes to the asset. Having an active fund allows the decisions to be made with minimal influence from the market changes and thus give the investor a unique opportunity to make their own decisions (Titan 446). It is also worth noting that, when funds are managed passively, they tend to perform better than their active counterparts. Fund invested passively do not suffer the influence of taxation and will have a higher value than active investment.

The decision to invest either passively or actively is entirely based on the availability of the investor and their level of understanding of the shortcomings of each. Having a clearer understanding of the conceptual basis of each investment, allows the investor to choose the best way they would like to invest their funds. With good management practices, the investor can make a profit regardless of where they decide to invest.

Types of Efficient Market Hypothesis

As discussed earlier, the acquisition of information is a vital step in the purchase and sale of assets. Since the market is primarily based on research to obtain material which could be helpful in the transaction of stocks, then the race to this goal has been the benchmark on which Efficient Market is judged. There are three types or forms of the efficient market; Strong Efficient Market, Semi-Strong Efficient Market and Weak Efficient Market.

Weak Efficient Market Hypothesis

The efficiency of a market can be measured by the rate at which information about the company is being transferred from one person to another. For a weak efficient market, the information about the company will be very slow and chances are the information gets to a group of people before it is made public. A few people then befit from the leaked information as they can make a better decision compared to their unaware counterparts.

A weak efficient market is hugely dependant on using past analysis and behaviour of the stocks to make decisions. This system deprives the investor a fair opportunity about how the company is doing. While a pretty accurate prediction could be made from knowing the business history, there are chances that the person with a better understanding of the current affairs will make better decisions.

Such a kind of market is also unfair in that executive from a company could easily gain a profit by leaking the information to an outsider after they learn about, so this second party is in a position to purchase shares which they can later sell at a higher rate after the company's information is made public. Buying and selling will then be compromised because the investors will not be equally reached by good or bad news about a company.

Semi-Strong Efficient Market Hypothesis

In this market, the acquisition of information is quite slow. Although it cannot be compared to the slow efficient market hypothesis, here the information moves at a faster rate. However, there is manipulation because the information reaches the investors at different times and hence the investors have different chances of making better decisions. Dispatch of information will be limited to a small section and the expected profit through such transactions could be minimal (Titan 443).

In this market system, those who are curious and do a lot of research will more likely stumble upon vital information that could be used in the decision-making process. All the past information is available to the participants in this market and a highlight of all public information. The predictions on this level will depend on skill and the experience of the investor. Even though investors still do not a fairground for prediction of rates, the overall performance will depend on the individual.

Strong-Efficient Market Hypothesis

Here the rate of information transfer is high and all information relevant to the company's performance and improvements or downfall will reach all the players (Investors, Executive and the general public) at the same time. The decision-making process will be restricted to hard work and analysis and there is no shortcut for a "get-rich-quick" expedition. For every participant, there are equal chances for making a good purchase (Titan 446).

Importance and Shortcomings of the Efficient Market Hypothesis

The EMH emphasizes that there are chances that an investor can make correct predictions regardless of the section they are in. it also claims that investors are highly influenced by new information that they can be convinced to change their decisions. This overreaction, according to the Efficient Market Hypothesis, is on the fact that any changes could change how the company performs and result in the change of the resultant stock values. This system has also been claimed to be misleading because, while it claims the analysis done by the investor is a waste of time, this analysis can be important because it helps form the basis on which the decisions are made. It has been observed that companies with a good improvement record are more likely to maintain the trend (Titan 446).

Fama is a renown business graduate who pioneered the concept of Effective Market. Fama went ahead to argue that the anomalies in the market are as a result of either an overreaction of the investors or and under reaction. He puts forward that the anomalies are not a result of the predictability of fluctuations, and that for a perfectly efficient market the expected anomalies should be zero.

Behavioural Finance

Excessive availability of information may be disastrous for the business. While it is generally believed that understanding the market structure and changes made can help the business quickly establish the profit it would make, it was also discovered that with the continuous streaming of information, the company may be swayed to make irrational decisions. It was then that the quest for understanding how investors make decisions was set out (Sujata & Jaya 52).

During the decision-making process, individuals tend to develop a perception of what they are getting. This attitude then enables allows the investor to make a decision. A problem arises when new information feeds into the system. It is generally observed that changing of an originally developed perception is hard and this may affect how the investor ends up choosing the asset.

Reaction to New Information

Another discovery was the tendency of investors to either overreact or under-react to information, either of each is crucial since it can be devastating to the decisions made. There are situations when the investor gets information and is reluctant to act to them immediately, this then affects the business if this information is vital in the expected results. In the event where the business does not put into consideration the information that could be important, they will end up with losses and destroy the very nature of the investment (Sujata & Jaya 50).

When making decisions, it has also been observed that mood and emotions affect how the person will decide which is the best for them. Given these conditions, when people are generally in a bad mood, they are more likely to make decisions in a rash manner. When one is not happy about any aspect of their life, they may end up transferring the same emotions to the business. On moody days; such as those rainy and cloudy, investors are more likely to make poor decisions and as result losses or weak investments that may not earn them much. On the contrary, when the investor is happy and in an enthusiastic mood, they will make brave decisions that will help them and be more profitable.

The Psychology of Masses

In a group of people, there is a trend in which the members tend to follow what others are doing. This urge to follow others and how they decide on what to do is among the major reasons for a drop in the way in which the investor comes into conclusion. When it is believed by a group that a certain person is good at predicting the result of an asset, the notion about what they say may mislead the members of the group (Sujata & Jaya 56).Having others as a role model is vital for growth, but then, one should not completely leave what they know just because someone they believe to know much about the topic has said a contradictory statement about the entity.

When making decisions, there are events in which the investor beats the market index and can end up in anomalies in their investment. The level of accuracy about the investments will be based on the availability of information. Occasional anomalies should not be interpreted to mean a constant expected increase in the investor's abilities. These anomalies will occur on some occasions and should be researched to establish the reason behind the misquoting of the prices.

Overconfidence

After trading for a while, an investor may develop confidence that whatever they do is set o be successful; this notion may also arise from the fact that an individual may have won many other businesses using the same method. Being overconfident may arise from an individual being in a position where the information reaching him is from a trusted source. Having such a source will most probably subject the investor to trust it even without proper consultation. A result of this will be an individual (Sujata & Jaya 54).

Tharler tried to explain how these decisions made by the investors were altered due to their interactive environment. It was then concluded that the decisions were not independently of the inventors but rather was an influence of how they interacted. It was earlier believed that the traditional method acted accordingly and that the investors...