Market Efficiency and Portfolio Construction

Market Efficiency and Portfolio Construction - Prof. Ali...

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Prof. Ali Reza Lecture notes : Market Efficiency and Portfolio Construction Efficient Market Hypothesis: Implications Note: In the following, “normal” or “average” rate of return refers to the rate of return one earns by buying and holding securities. When comparing the actual return from a security with a benchmark, we have in mind return on a risk-adjusted basis. Technical analysis : basic assumption is that there are patterns to security prices and these patterns repeat themselves. This permits one to earn above-average returns. This can occur if markets are inefficient that is it takes time for information to be distributed among, processed and acted upon by all investors. So it takes time for prices to move to a new equilibrium. Technicians can develop methods to identify when a movement to a new equilibrium starts after new information arrives; using such techniques the technician can trade securities and earn above-normal rates. There are many studies that refute the idea of persistent patterns in stock prices – suggesting that such “patterns” are mere illusions. Empirical evidence strongly supports the hypothesis that capital markets are weakly efficient. The evidence in support of semi-strong efficiency is weaker and that for strong efficiency is much weaker. Fundamental analysis : With fundamental analysis, one may be able to earn above-normal rates of return. But the requirement is that an investor’s forecast be both (i) correct , and (ii) different from the consensus. Evidence suggests that it is difficult to beat the market or the buy-and-hold policy – no superior analysts? But still if one believes that he/she can make correct analyses and these differ from the consensus, this suggests that fundamental analysis can help. If one can’t meet the correctness/difference criterion, then one should diversify one’s assets. Also important are: - Minimize taxes – saving on taxes is one of the best returns you can have - Reduce turnover – this reduces transaction costs, but can also help with tax exposure - Minimize liquidity costs – the gap between buying and selling price can be quite high on illiquid securities (munis, stocks that trade lightly,…). With illiquid stocks place limit orders near the specialist’s quote To diversify, one might as well buy an index. Many index funds (there are hundreds) came into existence to meet this need. Given the problems associated with trading mutual fund shares during hours when the exchange is open, one may want to consider ETFs (transaction costs tend to be higher than on many mutual funds). Portfolio Construction An asset provides a return; return can be in the form of a “dividend” and/or “capital gain”. If the return is known with certainty, it is said that the asset if risk-free. It is indeed difficult to find such an asset; one such asset is the U.S. TIPS. The return on assets is “uncertain” – thus “risky”. “Risk” can be defined in many different ways and
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This note was uploaded on 09/08/2010 for the course BUS 172A at San Jose State University .

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Market Efficiency and Portfolio Construction - Prof. Ali...

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