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Random Walks and the Efficient Market Hypothesis- Stock prices should follow a random walk, that is, that price changes should be random and unpredictable. A random walk would be the natural result of prices that always reflect all current knowledge. Indeed, if stock price movements were predictable, that would be damning evidence of stock market inefficiency because the ability to predict prices would indicate that all available information was not already reflected in stock prices. Therefore the notion that stocks already reflect all available information is referred to as the efficient market hypothesis (EMH). IN efficient market new information is incorporated into prices in a instantaneous and unbiased manner.A biased price reaction may be described as being an overreaction or under-reaction. An under-reaction will see the price gradually react to the new information and an overreaction will see an initial response to information and a subsequent revision to it.

Common Misconceptions about EMH  Efficient markets do not mean that you can't make money They do mean that, on average, you will earn a return that is appropriate for the risk undertaken and there is no bias in prices that can be exploited to earn excess returns Market efficiency will not protect you from wrong choices if you do not diversify 

If markets are weak form efficient you should not be able to use past prices to make an abnormal profit. Prices should reflect information contained in past prices and trading volume. This version of the hypothesis implies that trend analysis is fruitless. To test if this holds the relationship between past and present returns over short and long horizons are studied.Semi-strong efficiency is where prices reflect information contained in publicly available information. So it shouldn't be possible to predict abnormal risk-adjusted returns using publicly available information. There are many tests of semistrong-form efficiency that use an event study methodology to test whether secuirty prices adjust instantaneously to an event such as a public announcement.Strong form efficiency is where prices reflect information contained in public and private information. So investors such as company directors who possess private information should not be able to make abnormal returns from trading on this information. However we don't expect this because there are regulations that prevent/limit trades based on inside information. If this held then information contained in the reports will be instantaneously and unbiasedly incorporated into share prices, meaning investors should not be able to profit from following insider trades.

The best test of market efficiency is whether skilled investors can consistently earn abnormal trading profits. They shouldn't be able to if markets are efficient. TWo groups of professional investors who may be expected to  be well informed are analysts and fund managers. 

Behavioural Finance and the EMHThe behavioural finance literature argues that the anomalies discussed earlier are consistent with irrationalities observed in individuals when making complex decisions that is  Investors dont always process info correctly and therefore infer incorrect probability distributions about future rates of return Even if they have correct probability distributions, they often make inconsistent or systematically suboptimal decision. Irrationalities fall into two broad categories: first, that investors do not always process info correctly and therefore infer incorrect probability distributions about future rates of return,behavioural biases or the potential for investors to make decisions irrationally based on the information set they have access to even if this information is processed perfectly and limits to arbitrage or ability to profit from any mispricingInformation processing-  Can lead investors to misestimate true probabilities of possible events or associated rates of return Forecasting errors-People give too much weight to recent experience compared to prior beliefs when making forecasts and tend to make forecasts that are too extreme given the uncertainty inherent in their information.  Overconfidence- people tend to overestimate the precision of their beliefs or forecasts and tend to overestimate their abilities Conservatism bias (or under-reaction)- Investors are too slow in updating their beliefs in response to new evidence which means they initially underreact to news about a firm so prices will fully reflect new information only gradually. Such a bias would give rise to momentum in stock market returns.  Representativeness- people commonly do not take into account the size of a sample acting as if a small sample is just as representative of a population as a large one Behavioural Biases- Even if information processing were perfect, many studies conclude that individuals would tend to make less than fully rational decisions using that info. These biases would affect how investors frame questions of risk versus return and therefore make risk-return trade-offs. Framing- The way investment choices are framed can significantly impact how investors choose between them e.g. individuals may act risk averse (loving) if a gamble is posed in terms of gains (losses) Mental Accounting- Where investors segregate certain decisions e.g. they may take risks with their gains that they would not take with their principal Regret Avoidance- If outcome is bad, individuals have more regret when the decision was more unconventional Prospect Theory- This suggests unlike conventional finance theory which argues utility depends on the level of an investors' wealth, it actually depends on changes in wealth from current levels. Limits to Arbitrage- In practice, several factors limit the ability to profit from mispricing Fundamental Risk- It's risky to invest in stocks that are underpriced; what if the underpricing gets worse? Implementation Costs- Trading is not costless, transaction costs may make mispricing not worth exploiting e.g. when exploiting overpricing and short selling a security will entail costs, also, short sellers may have to return the borrowed security on little notice, rendering the horizon of the short sale uncertain. Model Risk- If valuation model is faulty, the stock might not really be mispriced.

Technical Analysis and Behavioural Finance- Attempts to exploit recurring and predictable patterns in stock prices to generate superior investment performance.Proponents of TA: Believe in recurring patterns in stock prices Agree that information about expected future performance of firms is useful but do not believe this information is necessary to formulate profitable trading strategiesBelieve that, regardless of the fundamental reason for stock price changes, if price adjustments are slow, trends can be identified and taken advantage of The Dow Theory posits three forces simultaneously affecting stock prices. The primary trend is the long term movement of prices, lasting from several months to several years. Secondary trend caused by short-term deviations of prices from the underlying trend line. These deviations are eliminated via corrections when prices revert back to trend values and tertiary trends which are daily fluctuations of little importance. Dow Theory based on notion of predictably recurring price patternsMoving averages- One version of this technique interprets average prices as indicators of the true worth of the stock, while another version takes moving averages as indicative of long term trends. Price breaks through the up/down trend indicate a bearish/bullish signal.Relative strength- The performance of a given stock over a a period is compared with that of others in the same industry. If the ratio increases over time, the stock is argued to display relative strength as it outperforms the chosen benchmarkResistance and support levels- These levels are identified as the points at which the stock price is unlikely to rise above or fall below respectively, and are believed to be a function of the market's psychology.Trading index- Here, both the volume of trading in a stock and historical movements are of interest:Trin= (Volume of declining/number declining)/(Volume advancing/number advancing) This statistic is the average volume in declining issues scaled by the average volume in advancing issues 

Fundamental Analysis- This involves selecting stocks for investment by examining fundamental determinants of value such as earnings and dividend prospects, estimates of firm risk and expectations regarding future interest rates. By doing this users of fundamental analysis attempt to estimate the present value of the cash flows that shareholders will receive from holding the stock and make trading decisions based on these calculations relative to the current stock price.Fundamental analysis involves the search for stocks that are going to perform better than the market expects them to. If markets are semi strong form efficient, fundamental analysis should generally not yield trading strategies capable of generating superior profits.

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