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OPINIONS

Understanding the Financial Marketplace

When was the last time you accompanied your mother to the wet market?

So I finally have some time to myself before the slew of exams upcoming.

I decided to accompany my mother to the wet market in the morning.

And I realized that I have no clue how the wet market works! Which fish is fresh, how to haggle prices, how to pick the sweetest fruits. And that is when I understood...

That understanding the financial marketplace as an investor is as important as understanding the wet market as a housewife/husband, allowing you to create a well-maintained portfolio.

So...

Have you heard of the Efficient Market Hypothesis

The efficient-market hypothesis (EMH) asserts that financial markets are informationally efficient and should therefore move unpredictably.

However, do you know that there are three versions of EMH?

Weak, Semi-strong, and Strong.

· In weak-form efficiency, future prices cannot be predicted by analyzing prices from the past. prices on traded assets (e.g., stocks, bonds, or property) already reflect all past publicly available information.

· In semi-strong-form efficiency, it is implied that share prices adjust to publicly available new information very rapidly and in an unbiased fashion, such that no excess returns can be earned by trading on that information.

· In strong-form efficiency, share prices reflect all information, public and private, and no one can earn excess returns. (Which is largely impossible due to regulatory bodies preventing insider trading from occurring)

Now, the consensus is that the market has a semi-strong-form efficiency, where the prices traded on the market fully reflect all publicly available information.

This means that:

· Stock prices respond immediately and fully to relevant information

· Stock returns are random and not predictable.

· Investors cannot beat the market

· Investors can utilize all forms of information efficiently.

The only reason that prices would change is if some relevant but unexpected information comes along. As such, stock returns are random and not predictable. Does this mean that Gasp Value Investing and Stock Picking does not work? There are many questions that have been raised about the validity of this theory and I would just like to explore them with you 😊

Let us look at some of the evidence against market efficiency, also called market anomalies. Researchers have documented many instances of market anomalies. Here is a shortlist:

  • Post Earnings Announcement Drift: Research has shown that Share Prices drift upward or downward for several months following good news or bad news in quarterly earnings.

  • Calendar Effects: Returns have generally been higher in January and lower on Fridays through end of Mondays.

  • Bubbles: The dot.com bubble, subprime mortgage bubble are classic examples of the stock market not following the EMH.

  • P/E or Value Anomaly: low P/E stocks produce higher risk-adjusted returns than high P/E stocks.

  • Small Firm Effects: that smaller firms, or those companies with a small market capitalization, outperform larger companies.

So how can we explain such market anomalies? Various explanations have been put forward to try to explain the market anomalies.

First, investors are rational, but because of transaction costs and for risk reasons, investors choose not to exploit the anomalies.

Secondly, The existence of noise traders. The noise traders do not trade based on information; thus, their trades might explain the anomalies.

Thirdly, Investors did not fully understand the implications of current earnings on future earnings. This could be because of bounded rationality. Investors intend to be rational, but they are only limitedly so, due to constraints of various kinds like time resource, mental limitations. Now, this is where behavioral finance enters the picture.

Some of the common behavioral biases:

  1. Limited attention: In reality, investors have limited time and limited resources to process information. Thus they do not always seek to optimize, but instead, they seek to satisfy. As such, investors tend to concentrate attention on the financial statements proper and ignore the notes in the annual report.

  2. Overconfidence: Now, overconfidence bias occurs when individuals overestimate their ability to predict future events. Now, many people exhibit signs of overconfidence. Within the stock market, overconfident investors may under-react to new information that is not self-collected relative to information that is self-collected.

  3. Representativeness: This is the extent to which an event is representative of individual impressions. As such, investors exhibiting these buyers may incorrectly judge information to be more representative than it is, and this may lead to wrong conclusions.

  4. Self-Attribution: This is a tendency to attribute good outcomes to our own skills and abilities and bad outcomes to sheer bad luck. Investor price momentum in the security market can develop if enough overconfident investors are self-attribution biased.

  5. Loss Aversion: Investors feel the pain of a loss more than twice as strong as the enjoyment of making a profit. As such, investors may be fearful of losses and end up focusing on trying to avoid a loss more so than on making games.

  6. Anchoring: The anchoring bias occurs when people rely too much on pre-existing information or the first information they find when making decisions.

  7. Belief perseverance: Investors may also search for information to justify their current beliefs and opinions and exclude information that contradicts those beliefs. It is the inability of investors to change their own beliefs even upon receiving new information or facts that contradict or refute that belief.

Now investors and analysts that exhibit behavioral biases in their decision-making may end up drawing conclusions and making trading decisions that are not consistent with securities market efficiency and the underlying rational decision-making. While research continues in this area, the general conclusion is that the securities market is relatively efficient.

What would I do as an investor then?

I would personally then utilize a Core-Satellite Portfolio Construction. Where the core portion of my portfolio will be managed passively, tracking an index fund. With additional positions, known as satellites, that are actively managed to earn greater returns than the market. This can be through Mutual Funds in sectors when I have limited attention/possess information asymmetry, or Companies I have personally selected after careful screening and analysis.

Talk more!

Ngooi​​​

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Helping S'poreans Fresh Graduates navigate #adulting and prepare them for their first steps towards Financial Independence.

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