Efficient Market Hypothesis - Experience

1. Weak-form EMH

Weak-form EMH has been the target that the academicians have won many victories to surpass the action of the technical analysts. Empirical results such as the autocorrelation analysis have been adopted to prove that yesterday's return is not correlated to today's return (I cannot ensure that tomorrow the market is still bullish, even though a stock has continued to rise in a long trend.), so that random walk is probably the movement of the stock price. Another test called filter rule (a kind of trading strategy by using the assumption of the reversal pattern) was proved to be failed to earn abnormal profit due to the existence of different transaction cost.

On the other hand, some academicians amend the filter rule and state that it is possible to extract abnormal profit through optimization. Technical analysts refute the empirical academists that some phenomena have been indeed the best circumstance to earn abnormal profit, implying that history has value to be a reference. Until now the debate of the weak-form EMH is not fully settled.

2. Semi-strong form EMH

As for the semi-strong form EMH, it is much more difficult to prove that it is satisfied even if the research is conducted in the most advanced and comprehensive financial markets in US. The fundamental analysis, in which the market practitioners endeavor to dig out the intrinsic values of the stocks, has been widely adopted by most of the financial institutions. There have been legends such as Warren Buffet, Peter Lynch who are reputable in investment history by using the fundamental analysis in different approaches (Value Investment, growth investment and their mix).

From my own point of view, to feel the power of EMHs needs some practical experience in market trading. I felt the power of the semi-strong form EMH through the value investment. In the evening, I discovered a stock which has low PE ratio and abnormally high yield. After the thorough research on the background of the target stock, the stock has good fundamental status (debt/equity, ROE, previous growths, etc.) it was found that it has lost a big sales order, which in turn overthrew the original expectation that the company should have robust growth trend. Furthermore, owing to the capital outflow, the market environment turned bad at that moment. Many financial institution has already sold this stock desperately.

The prospect of this company is not that bad as the competitors in Japan temporarily lower the price of their products in return for the market share. Japan has already overcome the turmoil of recession. In view of this, I regarded this as the value stock and decided to put my capial at stake next day.

In the morning when I woke up, I found that the stock price was originally stable. Unexpectedly, after the stock market started trading for an hour, the stock price rised suddenly. The price jumped for ten units while I could not have the initiative to buy the price as it seemed not to be valuable. Surprisingly, the stocks continued to rise so that it truely returned to the "normal" status.

That is my valuable experience to feel how the impetus of semi-strong form EMH is.

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Recently, the bull revives. When I re-observed this stock. It turned down to the valuable stocks once again. Is it truly valuable?

Efficient Market Hypothesis - Basic

To those who don't know much about finance: people always find some ways to predict the price of the equity (or some other financial instruments) through the historical information and the public information. Those who select the price series and the trade volume as tools are technical analysts, while those selecting the public information such as financial statements, announcement of the companies, and observable business operation are regarded as fundamental analyst. These are indeed quite common in today mass media that people are advocated to involve in the environment of forecasting, while controversy has been drawn for several decades in academic authorities regarding the validity of the statements announced by the above analysts. That is, to certain extent, are the statements useful for investment.

The proposition, Efficient market hypothesis (EMH), states that market (competitive financial market) is so efficient that every people under the same information set can never earn abnormal profit. The information set involves the help of 1) historical information, 2) current public information and 3) insider's information. If only 1) is satisfied, it is the weak form EMH. If 1) and 2) are satisfied, it is the semi-strong form EMH, and finally if all the information are revealed, it leads to strong form EMH.

Concretely speaking, if weak-form EMH exists, Mr. A cannot get on the rocket of the rise of the stock price, after hearing that price of stock X will rise tomorrow, as all people should have heard the same information which enables the price to rise immediately. It will be the same cases for the other information if the stronger EMHs are held.

Academicians use theory to prove that the ideal competitive market should get on the stage of strong form EMH. Weak form EMH eradicates the power of technical analysis which heavily focuses on the historical price and volume. Semi-strong form EMH has further eroded the power of fundamental analysis, and so does the value of insider's information when strong form EMH is satisfied.

Putting the academic theory aside, what can we observe in the real market? I would like to quote some empirical studies and personal experience to illustrate the situation.

Time to invest

The four-year period in the bachelor degree comes to an end. Luckily I could have an opportunity to take a rest from mid-June to July. World cup must be the most controversial event in this hot period. Right, I also spend much time on some other knowledge, including computer programming and investment. What I made is, to combine the information technology with the investment mind.

In the university life, I would say that the investment concept that I perceived is circumvented by the bulky mathematical formula, rather than the norm or mindset behind. All the mathematical formulae can be enjoyed by the mathematician, researchers in the universities, or most of the applicants in the structural product department in the investment banking. This seems to be out of the world of common sense. I am not saying that mathematics is too specialized that it has no contribution in the investment world, yet mathematics should be the advanced tools before approaching the market and feeling the breathe of the market.

Studying the rule of mathematics and adoring the mysterious discovery of Black-Schole Formula are enough for me (at this moment). I take certain steps to equip myself in order to feel how the impetus of the market is.

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To invest in the financial market can enable you to ride on the vehicle of marvellous return or dreadful roller coaster. Before the overwhelming jargons take place, certain crucial concepts should be firmly rooted in the mind. Reading some books about financial planning, I can indicate some points regarding this fundamental, yet important concepts.

- The first investment is your own health, for the sake of the continuous investment in the life time.

- The second investment is the education, which acquaints me with the theme of the financial market and financing activities.

- As economics always mentions that economic profit always equals zero under competition, information search, treated as the non-monetary opportunity cost, is the ultimate aim to sustain in the market. This includes the efficiency enhancement and the increase effort to have information acquisition. In my opinion, efficiency should be much more important. That's why I focus myself on the information technology development.

- Mentally speaking, After getting much knowledge, calm leads to rational analysis, while courage leads to critical success.

- Finally, what is money? Why do one have this, and how do one utilize this? On the one hand, earning one million dollar, yet spending two million dollar implies negative equity. Investment and financial planning is a marathon race to liberalize the entangled financial status. On the other hand, remember that nobody can pass away with the money permitted to enter the heaven. Social responsibility is the embodiment of the source of conscience, and the utilization of wealth.

I don't know if one can get used to this kind of concept during the investment, but to certain extent, concepts are important to design the strategy and direction. Let me talk more about the experience and ideas in investment later.