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Sunday, March 4, 2012

Efficient Stock Market Theory

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There are several hypothesis and theories which govern the markets all over the world. Efficient Market theory is a model about how the stock markets perform. This might be applicable to some stock markets and not applicable to others which are not efficient. Basically "Efficient Market Theory" states that Stock price or asset values are almost perfectly priced when factoring in all known information.

Now this theory about stock markets is actually simple and theoratically means that even if a monkey invests money in efficient stock markets he/she will perform no good or bad then a stock analyst person. Many novice people or people who are new to stock markets use this theory for investing in stock markets. Efficient market theory works in following order:

Consider a scenario where a listed company has just declared it's quarters earning report and you think of purchasing the stock. But you see that stock price has already risen by lets say some 'X' rupees, now according to Efficient market theory questions which comes to persons mind at this time like whether it is overpriced now? Has market overreacted to results? becomes of least importance. Whatever information (which made you think about purchase) has already been used and reflects in the stock price already, hence predicting future stock price of a company becomes irrelevent until actual information about the health of company comes out. Indian Stock Markets are least efficient because here corporates modify balance sheets and other monetary information about company while disclosing it in public domain. hence stock price of any listed Indian company might not show actual health of company, this is where speculators comes.

So if we categorize stock markets according to efficiency:

-A market has weak efficiency if prices fully reflect any information contained in past price data. Weak efficiency rejects technical analysis.

-A market has semi-strong efficiency if prices fully reflect all readily-available public information like earning reports etc.

-A market has strong efficiency if prices fully reflect all public and privileged information. Privileged information includes knowledge available to a market maker, or even the information used by analysts for their own use is available in public domain.

However efficient market theory is still unable to explain how legendary investor like Warren Buffett has outperformed the stock indices in all these years. So conclusion is that today's investment markets are not very efficient.


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