An efficient capital market(EMH) is one in which the current price of a security fully and quickly reflects all publicly available information about that security. This is a statistical concept. In a perfectly efficient market, investors should ideally use a passive investment strategy ( that is buying a broad market index of stocks and then holding it) because active investment strategies could underperform due to management fees and transactions costs. However, to the extent that the market prices are inefficient, then active investment strategies can generate good returns. One method of regulating a market’s efficiency is to determine the time it takes for the trading activity to cause the information to be reflected in security prices (i.e., time taken to disseminate information in the market). In some very efficient markets, this lag can be as short as a minute. If there is a significant lag in the dissemination of information, then informed traders could use the information to generate good positive returns.
According to the efficient capital market hypothesis, stocks always trade at their fair value on the market, making it impracticable for investors to either purchase undervalued stocks or sell stocks at higher prices. So, it is improbable to outperform the overall market through expert stock selection or market timing, and the only way the investor can get returns is by purchasing riskier investment. This concept of EMH is seldom possible is the real world as there always exists a gap between the dissemination of information and the price it reflects on exchange. For example, investors, like Warren Buffett, have regularly beaten the market over a long period, which by definition is unlikely according to the EMH.
Fundamental Analysis
Fundamental analysis is based on information which is available in the public domain such as earnings, dividends, and various accounting ratios and estimates, industry comparison, etc. The fundamental analysis involves delving into the financial statements. It involves looking at expenses, assets, liabilities, revenue, and all the other finance-related aspects of a company. The fundamental analysts look at this information to gain insight into a company’s future performance. Fundamental analysis involves a study of quantitative and qualitative factors. It refers to the analysis of the economic well-being of a financial entity as opposed to only its price movements. Its attempts to answer the question such as:
- How is the revenue of the Company going?
- Will the Company able to pay its debts?
- How is the cash flow of the Company?
- Is the management trying to cook the book?
It involves the proper study of the following
- Management discussion and analysis (MD&A) gives the investors a better understanding of the company.
- The balance sheet – the assets, liabilities, and shareholders’ equity.
- The income statement includes figures such as earnings and earnings per share., revenue, expenses, etc.
- The cash flow statement which tells how much actual money the company generated.
- Notes to the financial statements. They provide in-depth information on a wide range of figures reported in the three financial statements.
The various fundamental factors can be arranged into two categories: quantitative and qualitative.
- Quantitative –that is capable of being measured in numerical terms.
- Qualitative – that is related to or based on the quality or character of something.
The Fundamental analysis is often criticized by proponents of technical analysis and believers of the “efficient market hypothesis.”
Technical Analysis
The technical analysis seeks to earn positive risk-adjusted returns by using historical price and volume (trading) data. As opposed to Fundamental analysis, this analysis does not care about the “value” of a company or a commodity. This analysis just studies supply and demand in a market in an attempt to establish what path, or trend, will continue shortly. This means, technical analysis attempts to understand the emotions in the market by studying the market itself. However, technical analysis has shown to have success in emerging markets. Moreover, there are so many possible technical analysis trading strategies and they cannot all be tested. As stated previously, the success of the technical analysis strategy should be evaluated considering the costs of information, analysis, and trading. As there are numerous investment styles on the fundamental side, there are also many different types of technical traders. Some rely on patterns, charts, others use technical indicators and oscillators, and most use some combination of the two. Traders who like to go for Technical analysis take a short-term approach to analyze the market. Criticism of technical analysis originates from the efficient market hypothesis, which asserts that the market price is perpetually the correct one, making any historical analysis useless
The concept of Technical analysis is based on the following analysis
- The Market discount itself
- Price moves is a trend
- History tends to repeat itself
Technical analysis can be used for any security with historical trading data like commodities, stocks, futures, fixed-income, forex, securities, etc.