RANDOM WALK Model and EFFICIENT MARKETS HYPOTHESIS

Dow through editorials in Wall Street Journal (1885-1900)encouraged speculation publicly.

Counterview: Stock prices follow random walk in short periods of time.Short period returns are random variables.

Evidence: Serial Correlation Tests, Runs tests, Filter rule tests


Serial Correlation: For the same scrip, Correlation between price change of today and price change of yesterday or more generally Correlation between price change of today and price change of some previous day.

If serial correlation is close to zero, there is no relationship between previous period's price change and today's price change. In this case estimating future price changes using past price changes is not possible.

serial correlations were found to be close to zero in a number of studies.

Weak Form Efficiency: Stock prices reflect all the information present in the historical price series. There is no benefit in examining the price series any more.

Semi-strong Form of EMH: The stock prices reflect all publicly available information.
Trading using fundamental analysis will not give profits above the returns from buy and hold strategy.

Indirect approach: Concerned with the user of information, and how he performs over time against some yardstick such as the market average. One obvious method is to compare the performance of professionally managed funds against a simple passive strategy of buy-and-hold-the-market. Celebrated test - study by Jensen,M.
Performance of 115 mutual funds over the period 1945-64 was examined.
He found that the funds on average were unable to outperform a passive strategy and that no individual fund was able to perform better than could be expected from random chance.

Counter Evidence through Cross sectional Studies:
Low P/E stocks
Low P/B stocks

Anomalies

Strong form of EMH(According to Black): The market price generally reflects all avai- lable information and the most ignorant investor buying at current prices gets the benefit of everyone else’s thinking.
It is not that stock prices are insensitive to changes in the prospects for a company or for the economy.Rather it is that prices are very sensitive to these changes.
The price changes so fast that no one has time to make money on the information.The strong form of the EMH claims that no one can consistently earn a profit higher than what could be earned with a naive buy and hold strategy by short-term trading.

The strong form of EMH is not found to be quite acceptable.
A few cases of monopolistic profit making are found which violate this hypothesis.
- Specialists on the exchanges
- Insider trading.
Comprehensive Reference: Stock Market Efficiency : Theory, Evidence and Implications, Simon M.Keane, Philip Allan Publishers Limited, Oxford, 1983

Modern Portfolio Theory - Practical Application

Modern portfolio theory either Markowitz method or sharpe method or any other simplified method can be applied to real life data provided you have target prices for all the scrips that you want to consider for inclusion in the portfolio are available.