Investment theory Essay

The efficient market hypothesis (EMH) is an investment theory that states it is impossible to beat the market because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to this theory, the stock always trade at their fair value on stock exchanges. This makes it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. EMH provides that it should be impossible to outperform the overall market through expert stock selection or market timing. The only way an investor can possibly obtain higher returns is through purchasing riskier investments (Answer. com, 2006). Using the EMH theory, this research study will examine the efficiency of the United Kingdom (UK) stock market indices by providing an internal performance comparison between FTSE 250 and FTSE AIM. A total of two hundred (200) companies will be used for the analysis, with one hundred (100) companies from each index, on the basis of trading value from all sectors, using Datastream platform. Two inputs (total sales and EBIT), and two outputs (total capital employed and total assets) will be used to analyse the data from each company. Literature Review Although EMH is deemed the cornerstone of modern financial theory, it has also been highly controversial and much disputed. Critics say it is pointless to search for undervalued stocks or to try to predict trends in the market through either fundamental or technical analysis. A review of related literature however will show that a large body of evidence show support of EMH. While academics point to a large body of evidence in support of EMH, an equal amount of dissension also exists. For example, investors such as Warren Buffett have consistently beaten the market over long periods of time, which by definition is an impossibility according to the EMH. Detractors of the EMH also point to events such as the 1987 stock market crash (when the DJIA fell by over 20% in a single day) as evidence that stock prices can seriously deviate from their fair values. (Answers. com) In finance, the efficient market hypothesis (EMH) asserts that financial markets are â€Å"efficient†, or that prices on traded assets, e. g. stocks, bonds, or property, already reflect all known information and therefore are unbiased in the sense that they reflect the collective beliefs of all investors about future prospects. The efficient market hypothesis implies that it is not possible to consistently outperform the market — appropriately adjusted for risk — by using any information that the market already knows, except through luck or obtaining and trading on inside information. Information or news in the EMH is defined as anything that may affect stock prices that is unknowable in the present and thus appears randomly in the future. This random information will be the cause of future stock price changes.