Finance: Applied Investment Strategies

The Financial and Economic Context of Investment

Every single investor is interested in maximizing investment returns while simultaneously minimizing risk subjected to the investment. Consequently, investors prefer committing their resources in receptive economic systems free from uncertainties that may hamper their anticipated returns. In practice, the investors find their desire hard to accomplish given that they are frequently required to deal with emerging constraints arising in the economic and financial sectors. Of great concern here is the price which investors pay in form of hurdles emerging from the economic vicious circle comprising deepened sovereign-debt crisis, slowing economy and fragility in financial institutions. The contemporary business enterprises operate in a complex economic system where multiplicative factors exist in forms of weak public debt sustainability, global pressure in the sovereign debt markets, and the vulnerability of banking sector through sovereign exposures alongside the global recession(Bekx, 2012, p. 4).It is for the above mentioned factors that countries in the Euro area have devised new measures to respond to the five-year financial crisis. In reality these measures are directed to address the removal of market uncertainties relating to member states, conducting budgetary consolidation and growth in vulnerable member economies, establishing economic firewalls against contagion in the sovereign debt markets, reinforcing the EU banking sector, and strengthening of the euro-area governance framework (Bekx, 2012, p. 11).

Regardless of the nature of strategies adopted by the economic union and individual member states to solve the financial crisis, there is a need to consolidate corrective actions placed on all players in the economic context. As such will include the impact of financial intermediaries, non-banking financial institutions, and borrowers regarding how each party should execute their responsibilities to avoid recurrence of similar economic shocks. For instance, most weakening economies attribute the failure of the market to the current level of liquidity access relative to the overall national outputs. To this far, the failure of financial sector cannot be singled out as a one-party input since current studies reveal that each of the aforementioned parties had its share of contribution in the pooled failure.

Unless the individual economic systems innovatively adopt better management of risks and navigation approaches through thoughtful regulatory reforms, leading role adopted by global institutions may only bear theoretical solutions to the menace. Empirical observations reveal the shocking impact of the financial debt crisis that entangled the mature economies emerged from volatility in isolated public-private dialogue (Institute of International Finance, 2012, p. 11). Consequently, economic difficulties spreading across the economies can only be mitigated through institutional competencies, regulatory reforms and concerted action involving the private and the public authorities into the dialogue of restoring investors’ confidence in the economy. However, a collaborative approach of all constituent players is essential to strengthen the global financial and economic system while cautioning against the risk of fragmentation of the regulatory framework in member states. This requires striking the balance for the economic systems to nurture the voice of perfect information flow in the market to eliminate uncertainties hampering financial systems.

Efficient Market Hypothesis

In practice, all world economies race to accomplish market efficiency by eliminating imperfections surrounding the constituent economic systems. Nevertheless, attaining efficiency in the economic system has become a sensitive and complex issue signalled by the economic recessions and incidences of collapsing financial markets. This is demonstrated by the effect of inefficiency to the present behaviour observed in the operations of financial institutions and security markets. Efficient market Hypothesis (EMH) represents a proposition that the current movement in stock prices, is a full reflection of all available information about the intrinsic value of the firm, and there is not a single opportunity one would garner excess profits by using such information as it is available publicly(Clarke, Jandik, & Mandelker, p. 1). This implies that there exists no instance of mispriced securities as competition arising in the security market, forces the full effect of available information to be instantaneously reflected in actual prices of the stocks.

The hypothesis holds a contrasting view of the investors’ practice of committing their financial and time resources to identify undervalued stocks in order to outperform the market in the event of appreciating stock prices. This contravenes the motive that investors and portfolio managers have when selecting securities by employing forecasting approaches and valuation techniques to assist them construct their investment portfolio.EMH asserts that none of those techniques will effectively translate into benefits that may exceed transaction and research costs incurred(Clarke, Jandik, & Mandelker, p. 2).Therefore there are no instances that one would outperform the market by using what is publicly available as any information is instantly incorporated into the security prices.

New information remains the key determinant in stock price movements. Consequently, the standpoint presented by EMH that benefiting from predicting price movements is very difficult and unlikely as the current prices of securities will always reflect all available information regarding the company at any point in time(Clarke, Jandik, & Mandelker, p. 2).This eliminates the perception to believe there are existing instances of mispriced securities as prices quickly adjust on arrival of new information, even before investors get time to trade on such information.

EMH further appreciates that market efficiency results from intense efforts to compete amongst themselves to profit from newest information on the securities. In practice, as the level of competition among investors of the view that mispriced securities exist, chances of coming by those securities will subsequently decline as search intensifies. This conforms to Fama’s proposition that, securities are always priced in relation to the information that any single investor may access, and thus decreasing chances of fooling investors outperforming the market. Consequently, payoffs from the information that investors may obtain will never outweigh the cash outflow incurred in the form of research and transaction costs. Under Fama’s interpretation of the EMH, the impact of sophisticated investors is so strong in the market, that they reduce the dispersion of an actual price distribution close to their expected value (Alajbeg, Babies, & Sonje, 2012, p. 56).

Fama and Samuelson, like many other scholars in applied investment gave their interpretation of the EMH stance on how market efficiency is attained. The latter arrived at the axiomatic approach which recognized that efficiency in the market is reached in conditions of perfect competition, zero transaction costs, complete and freely available information. Contrariwise, Fama interpretation held that efficiency is an actual outcome of sophisticated investors seeking to profit from the newest information. However, the EMH position on fair pricing in the efficient market does not imply that all securities will show similarity in their market performances. The hypothesis affirms that the price of securities exist as a primary function of risk and present value of expected future cash flows, while incorporating information on factors such as volatility, liquidity and risk of bankruptcy. EMH emphasizes that while security prices are rationally determined, changes in the pricing of the securities are random and unpredictable given the nature of unpredictability of new information. As a result, financial researchers have identified three versions of EMH.

Firstly, the weak form efficiency holds that the current prices of securities will fully integrate all set of information which can be obtained from past history on stock prices. This implies that no single investor will profit from analysing past information regarding the security pricing. This position dispels technical analysis technique adopted by investment analysts in an attempt to study the past sequence of prices. This implies that past stock market prices cannot be used profitably to forecast future prices, clearly rejecting input of technical analyses, which counts on historical price patterns to predict future market movements (Xie, 2011, p. 208).Empirically, the weak form shows consistency as transactions cost and resources committed to conducting market analysis outweighs any benefit which might be obtained from the publicly available information.

Secondly, the semi-strong EMH propose that current security prices always incorporate all information available to the public. This information includes past reports on stock prices, annual statements of financial position and periodic filings by the security exchange commission (Clarke, Jandik, & Mandelker, p. 5).Naturally, such public information is not restricted to financial matters as it incorporates information regarding future management structures, planned investments and development in the firm. A similar position to that of weak form hypothesis is held in the semi-strong hypothesis; investors cannot profit from using information that is publicly known. However, creating strong market efficiency in the security markets requires the existence of market analysts to interpret vast financial information, and macroeconomists expertise to understand input and product markets (Clarke, Jandik, & Mandelker, p. 6).

Arguably, acquisition of expertise of such nature demands a lot of time and substantial effort. Additionally, gathering all information regarding the company present and past information that may influence investment decisions us costly to bear and difficult to process. For instance, one will need the services of professional analysts to gather relevant interpretation in the vast information including industry reports, financial research and management journals, annual company publications and databases, to effectively track the price movements. Consequently, no publicly available information can be profitably exploited for profit; dispelling importance of conducting fundamental analysis as such cannot be used profitably for active investment management (Xie, 2011, p. 208).

Lastly, the strong form suggests that current prices of securities fully incorporate all information existing in both public and insider forms. This implies that no investor has the ability to profit in the event that one is trading on insider information. Consequently, the management team will not systematically gain from inside information by purchasing company shares to gain from information they have not dispatched to the public. This contradicts the perspective of insiders who purchase securities on perception of very profitable acquisition. Here, the efficient market theory holds that not even private information can be used to forecast future market returns. The strong market efficiency is based on the rationale that the market anticipates future developments and changes in the company which are incorporated in the stock prices in an objective and much informative manner than the insiders (Clarke, Jandik, & Mandelker, p. 7).However, if the strong market form would show consistency in practice, this would discredit the value of rules put in place to eliminate insider trading.

Application of EMH Theory in Real Financial Markets

Over the years, mankind has applied a range of techniques in an attempt to analyse and trace economic series regarding stock price movements. However, interpretation of the data obtained was found not to predict accurately future price movements as earlier anticipated. In conclusion, financial economists have identified that stock markets are erratic and do not follow logically rules. The irrationality originally perceived to characterize the markets is now apparent to exist in the form of random price movements indicating an efficient market (Vialar, 2009, p. 229).For instance, if future prices were predictable, this would act as a virtual goldmine for investors who would buy mispriced securities and sell the overvalued stocks to realize substantial gains. However, in a scenario where prices of a particular stock are expected to rise in a few days, investors would create an immediate wave of purchase orders but not a single stockholder would sell such security. Consequently, there would be an immediate rise in the stock price reflecting the good news in the forecast. Unsurprisingly, any piece of information that investors may apply in the prediction of stock performances in the market is immediately reflected in the stock prices. Therefore, evolving stock prices is an essential consequence of effort applied by intelligent investors competing to discover relevant information to reach investment decisions (Vialar, 2009, p. 229).

Predicting stock price movements in the real financial markets is anticipated by investors to translate into higher returns. However, the level of competition emerging from the number of investors striving to obtain such information leads to immediate adjustment of stock prices before the investor trades on such information. Reflecting on the three versions of EMH earlier identified, it reveals the implication they have on operations in the real financial markets. Firstly, trend analysis is fruitless since the stock prices already reflect all information that an investor can obtain in the history of past trading(Vialar, 2009, p. 232).It is therefore baseless to commit time and resources to analyse stock prices and trading volumes publicly obtained at minimal cost. As investors compete to exploit useful knowledge from stock’s price history, they drive the prices to levels where such expected rates of return correspond to risk (Vialar, 2009, p. 233).Within those levels, investors will not expect abnormal returns in such stocks.

Secondly, the semi – strong form of efficient market theory perceives that undertaking fundamental analysis to provide insight to future performances will definitely fail. There exist a considerable number of well-informed and financed firms conducting similar market analysis, and in such level of competition it is difficult to uncover more accurate information than other rival analysts (Vialar, 2009, p. 234).This implies that using a similar source of information, discovery of good stocks is no good for the investor as others too will have known such good firms as well. Investors will pay higher prices while investing in stocks of such companies, consequently reducing their anticipated higher returns. Lastly, the strong form of market efficiency shows inconsistency in the real financial markets practice where regulations are put in place to eliminate trading on insider information that negatively affects the stock prices.

Economic Factors Affecting the Efficiency of Markets

Over the years, most economies have recognized the potential emerging from competitive environments. In practice, economic efficiency is stimulated, productivity is improved, innovativeness increased. The above together with economic growth are some of the benefits that characterize efficient market environments. Additionally, regulations governing market competition have played an important role in disciplining conduct of most businesses and preventing unfair practices in the market. However, creating a level playing ground for all parties has become a tough objective to accomplish in the existence of economic factors hampering market efficiency.

To begin with, the existence of a conflict of interest between different economic agents has created disorganization of the market yielding market segmentation. Such market segments act as receptive ground for unethical market agents to exercise unfair market power. This makes it difficult to accomplish market efficiency as information required by other parties is highly restricted. Therefore, some firms will profit when they trade in knowledge obtained from withholding information. Secondly, lack of perfect information on issues regarding market demand and supply forces limit the operations of some firms leading to inefficient markets where few are in the leadership roles yielding monopoly power(Singh & Ellis, 2010, p. 4).This may arise where the market comprises organized segments and informal market.

In addition, preferential treatments accorded to the public enterprises create comparative advantages relative to the private firms. Public enterprises have better access to capital and resources creating un-level environment where private companies lack the head-start. Such economic discrimination affects the market efficiency both directly and indirectly as investors prefer securing their wealth in companies whose operations are not highly inhibited by the ruling authority.

Moreover, market efficiency is dependent on the activities of financial and non-financial intermediaries, regarding the flow of market information is essential to create informed decision making. For instance, presence of brokerage firms in the financial markets will induce timely investment decisions amongst the investors. Lastly, the existence of the huge financial burden will hamper efforts to attain market efficiency as investment activities will be subject to unstable economies (Babu, 2007, p. 165). This arises when the host country fails to meet its debt obligation as and when they fall due leading to the debt crisis in the economic system.

Government Interventions to Influence Investment Portfolio Performance

With the consequences of the five-year financial crisis still unfolding and the escalation of sovereign debt across Euro area, individual government is required to intervene to speed up the recovery process. Similarly, this will involve erecting measures that will prevent recurrence or minimize the escalation of consequences in the event of such incidences. Firstly, the government should conduct an informal dialogue between the public and private sectors to create fair and ethical practices that will bring clarity in the financial markets. This may be in the nature conducted in Greece following its debt crisis where the government engaged the Institute of International Finance on a historic voluntary debt exchange (Institute of International Finance, 2012, p. 42).

Secondly, the government may intervene by analysing and addressing challenges for long-term investment and asset allocation decisions arising from both market dynamics and regulatory reforms(Institute of International Finance, 2012, p. 42). For instance, where public systems have undeniable advantages over the private firms, investments are subject to delayed time of recovery such as Cyprus. Investment borrowers from the state-owned banks enjoy interest rates relative to borrowers from privately-owned banks but tend to be less profitable and riskier(OECD, 2009, p. 6). Conducting financial regulatory reforms will hedge the entire market against the loss of confidence in the major financial institution in the event of a crisis. This prevents snowballing arising in instances where investors lose confidence in the entire market, when major institutions fail to meet their obligations plunging other small institutions into insolvency(OECD, 2009, p. 7).This will eliminate regulatory failure which escalated the current crisis and not the failure of individual markets and investment competition.

Third, the government may intervene through nationalization of the financial institutions enhance coordination in the financial sectors during periods of financial crisis in a similar approach to Ireland and Iceland. This will reduce contagion effects to the security exchange markets since the government will oversee the coordination of the financial intermediaries, enhancing full implementation of the regulatory reforms. The government will then privatize the institutions again to enhance liberalization of the economy, and level the playing ground. This restores the investors’ confidence when the government conducts regular oversight and enforce quick response to avert systemic crisis witnessed in Spain. Lastly, the government may set up capital injections and guarantee schemes to cover liabilities of financial and investment institutions (OECD, 2009, p. 9).

References

  • Alajbeg, D., Babies, Z., & Sonje, V. (2012). The efficient market Hypothesis. Financial Theory and Practice, 36(1), 53-72.
  • Babu, G. R. (2007). Portfolio Management (including Security Analysis). New Delhi: Concept Publishing Company.
  • Bekx, P. (2012). The European Sovereign Debt Crisis and the Future of the Euro. European Commission, Economic and Financial Affairs.
  • Clarke, J., Jandik, T., & Mandelker, G. (n.d.). The Efficient Markets Hypothesis. Retrieved April 18, 2013, from http://e-m-h.org/ClJM.pdf
  • Institute of International Finance. (2012). Response to the Global Financial Crisis 2007-2012. IIF.
  • OECD. (2009). Competition and Financial Markets. Retrieved April 19, 2013, from http://www.oecd.org/daf/competition/43067294.pdf
  • Singh, R., & Ellis, K. (2010, May ). Political Economy Factors Affecting Effecient Functioning Markets. Retrieved April 19, 2013, from http://www.thecommonwealth.org/files/224294/FileName/THT73 PoliticalEconomyFactorsAffectingEfficientFunctioningofMarkets.pdf
  • Vialar, T. (2009). Random Walks and The Effecient Market Hypothesis. Retrieved April 19, 2013, from http://highered.mcgraw-hill.com/sites/dl/free/007338240x/773409/Sample_Chapter_8_New.pdf
  • Xie, X. (2011). Full View Integrated Technical Analysis: A Systematic Approach to Active Stock Market Investing. West Sussex: John Wiley & Sons.
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