Efficient Market Theory

You may have heard of something called the Efficient Market Theory. If you did, it was almost certainly in a negative context, some writer or blogger excoriating those egghead finance professors for confusing the world with their crazy and dismal theories. This is a rant mostly heard from the advocates of investing in individual stocks, but is also found occasionally in the arguments of those in favor of active funds over passive (index) funds and market timing over passive asset allocation.
Apparently, this poisonous heresy has been spread by overly educated academics near and wide for decades. They convince their innocent students that it is categorically impossible to make money picking stocks, that anybody who does anything other than buy an index fund is a fool. It’s a viewpoint that is not just wrong, it’s dismally pessimistic and, let’s face it, simply un-American.

The efficient market theory states that the stock market reacts very quickly to new information, so at any given time the market contains the sum of all investors’ views of the market.

What does this mean to the average investor? Imagine you are reading an article in the Wall Street Journal. Dell is going to release a new computer in three months that will blow away the competition. You think maybe tomorrow you’ll call your broker and buy Dell, because obviously the price will go up.

The efficient market theory states, in no uncertain terms, you are too late! If you bought Dell stock as soon as soon as you read the article, or even as soon as it was printed, you are still too late. A lot of more savvy investors and traders bought the stock before you, and drove the price up. It doesn’t matter that the new computer won’t be released for 3 more months. Whoever buys the stock first wins.

What does this mean to the savvy trader? Even if you have the fastest tools and the best information, you still have to work for it. Trading is a competition. No strategy will always work. That’s impossible, because in order for someone to win, someone else has to lose.

An oxymoron is a figure of speech that deliberately uses two contradictory ideas. This contradiction creates a paradoxical image in the reader or listener's mind that generates a new concept or meaning for the whole. Some typical oxymorons are:

• a living death
• sometimes you have to be cruel to be kind
• a deafening silence
• bitter-sweet
• The Sounds of Silence (song title)
• make haste slowly
• he was conspicuous by his absence

Recently the efficient market theory has been misquoted a lot. The efficient market theory does not say that the market is always correct. It says that the market represents the sum of the information available and the choices made by traders and investors. Traders and investors can be wrong. Information can be wrong. The best opportunities come when the market is temporarily wrong. The smart traders will find the difference between the market value of a stock and the ideal value before the rest of the crowd does.

One successful strategy that many of our customers use is called “mean reversion.” This strategy is based on the idea that the market is not 100% efficient. Time after time, the market will overreact to bad news. Prices will move much further than they should. Then they will move back toward normal.

A MARKET EFFICIENCY STORY

An elderly economics professor was walking down a busy street with one of his energetic students to the local café for lunch. Along the way, as he was explaining the concept of market efficiency to his student, the professor stepped right on a wadded up $20 bill and continued to stroll on. The student, who was looking down in studious thought at the time, was amazed at his good fortune and stooped down to pick it up. As the student rushed to catch up with the professor, he asked the professor whether he had seen the $20 bill.

The professor quipped "My dear lad, haven't you been listening to anything I have been saying about efficient markets? Although I saw the $20, I knew my eyes must have been deceiving me. Efficient markets theory dictates that it couldn't possibly be there because if it had been, someone else would have already picked it up."

The story above is an old joke among economists. It highlights both the conclusions and possible folly of assuming the extreme case of efficient market theory. Most scholars believe (in one form or another) in efficient markets. Although there are several forms of what is referred to as the "market efficiency hypothesis," its basic premise is that all stock prices accurately reflect all historical and current information. This means that whenever you purchase a stock, you are getting the best price based on available information. If the stock you chose was truly undervalued, investors would have already been buying the stock and thus pushing the stock price up until it was considered accurately valued. The opposite occurs for overpriced stocks. In essence, the theory states that there are no $20 bills, or even $1 bills just lying around for you to pick up. When was the last time you found a $1 bill lying around? This is market efficiency at work.

In support of this theory, many studies have shown that picking stocks by throwing darts at the stock table is just as likely to earn you profits as listening to the "market experts."

EMH was conceived as a null hypothesis in the 1950s and 60s. On the slim chance that you are unfamiliar with the term, I will summarize. A null hypothesis is a reasonable, obvious, and often naive interpretation of data to explain what is going on. You invent it as the alternative to the new clever theory you are trying to test. “The Earth is flat” and “heavier objects fall faster than lighter ones” are examples of great null hypotheses from history. A key thing to remember about null hypotheses is that they do not need to make sense in the big picture, they exist only as simple explanations that can be disproven to justify more complex ones. The Earth is flat has a lot of issues as a theory, e.g. what happens at the edge and how the objects in the sky work, but it is largely consistent with ordinary daily experience.

EMH states that stock prices reflect all available information at any given point in time. Stock prices instantly change to reflect new information as it arrives and those changes will by definition be unpredictable and random, because anything that could have been anticipated would have already been baked into the previous price. As a result, you cannot make money picking stocks.

It’s not clear that when EMH was born any serious researcher believed it as a theory of how the real world worked. It was thought up as a straw man against which it could be proved that you could indeed make money picking stocks, particularly with some “technical” and “chartist” theories that were then popular and, with the advent of computers, could for the first time be tested methodically.

But when the professors used the computers to look at the data, EMH turned out to be very very hard to defeat with statistical significance. In fact, it would be decades before it would be done conclusively.

This simple empirical observation, that stock prices appear to be unpredictable and random and that it is (almost) impossible to demonstrate any way in which they are not random, had far-reaching and profound implications. The most important one with regard to our understanding of finance is that you can model the movement of stock prices as if they were random walks. Just about all the useful stuff to come out of 20th Century financial theory was based on this trick, including our understanding of how to diversify portfolios and value options and other derivatives.

But as useful as EMH is as an assumption, it is lousy as a grand theory of how the stock market, or other financial markets, work. Like the Flat Earth Theory, it collapses in on itself if you think about it too carefully. Any explanation of how EMH could be true has to start with lots of clever stock traders that collectively find the perfect, all information reflected, true price. As new information arrives, those traders instantly move the price appropriately. And how does that dynamic work? How do those traders wind up with the right price? There must be an economic reward given to the smart traders for getting the price right and a penalty for getting it wrong. In other words, it must be that some traders make money picking stocks, which violates EMH.

So even though they may appear to be random, for some traders some of the time, stock price movements are not actually random but are at least mildly predictable. To use a possibly strained sports analogy, the flurry of gestures the catcher makes tells the pitcher what to throw, but are presumably meaningless to the runner on second. To the runner, even though he knows the signals are meaningful to the pitcher, they can best be considered random noise.

Thoughtful people who understand the stock market don’t say that it can’t be beaten, they say it is very hard. So hard, in fact, that it is unwise for all but a few to even try. This got simplified by less thoughtful people as a belief that the market was perfectly efficient and that all market outperformance, even by Warren Buffet, was due to random chance.

The difference between stock price movements being actually random and might-as-well-be random may seem academic, but is not. Firstly, the arguments made by advocates of stock picking against the Efficient Market Theory should impress no one. Just because it makes no sense that beating the market is fundamentally impossible, it is not true that anybody can beat the market.

Secondly, while the evidence around EMH makes a good argument that an individual investor should not expect to successfully pick stocks, it does not follow that there do not exist professionals who can beat the market. Arguing, as many do, that investing in an active fund is pointless because all fund managers are the equivalent of monkeys throwing darts is specious. (On the other hand, the analogous argument that an individual investor is unlikely to be able to separate the monkeys from the geniuses, i.e. that picking mutual funds is no easier than picking stocks, has more than a little merit.)

And finally, it is worth observing that for many advocates of passive investing, their belief in the efficiency of markets is (appropriately) shallow and limited. It is quite common, for example, and I think John Bogle subscribes to this, to believe in equity index funds but to advocate very large allocations to equity as an asset class, in some cases approaching 100%. This is not consistent with a belief in efficient financial markets.

Allocating most of your money to stocks is itself an active decision that only makes sense if you believe that stocks as an asset class are cheaper than they should be. If you thought the markets were perfect then you would assume that all asset classes, stocks, bonds, real estate, gold, etc., were priced such that on a risk-adjusted basis they all had the same expected future return. Putting all or nearly all of your money in one class would then make no more sense than putting it all into a single stock. You would get no improvement in risk-adjusted expected return, since that is impossible, but would greatly increase the risk you were taking on.

That’s not an unreasonable argument, and one that is perfectly consistent with Efficient Market Theory as I understand it. And yet I’ve never heard it anywhere. Is it possible that this great and sinister theory isn’t quite as widespread as its detractors claim?

Foreign Institutional Investors ( FII )

Institutional investors are organizations which pool large sums of money and invest those sums in securities, real property and other investment assets. They can also include operating companies which decide to invest their profits to some degree in these types of assets.

Typical investors include banks, insurance companies, retirement or pension funds, hedge funds, investment advisors and mutual funds. Their role in the economy is to act as highly specialized investors on behalf of others. For instance, an ordinary person will have a pension from his employer. The employer gives that person's pension contributions to a fund. The fund will buy shares in a company, or some other financial product. Funds are useful because they will hold a broad portfolio of investments in many companies. This spreads risk, so if one company fails, it will be only a small part of the whole fund's investment.

An institutional investor can have some influence in the management of corporations because it will be entitled to exercise the voting rights in a company. Thus, it can actively engage in corporate governance. Furthermore, because institutional investors have the freedom to buy and sell shares, they can play a large part in which companies stay solvent, and which go under. Influencing the conduct of listed companies, and providing them with capital are all part of the job of investment management.

FII is defined as an institution organized outside of India for the purpose of making investments into the Indian securities market under the regulations prescribed by SEBI. Positive tidings about the Indian economy combined with a fast-growing market have made India an attractive destination for foreign institutional investors.

These investment proposals by the ‘FII s’ include “Overseas pension funds, foreign corporates, individuals, mutual funds, investment trust, asset management company, nominee company, bank, institutional portfolio manager, university funds, endowments, foundations, charitable trusts, charitable societies, a trustee or power of attorney holder incorporated or established outside India proposing to make proprietary investments or investments on behalf of a broad-based fund.

FIIs can invest their own funds as well as invest on behalf of their overseas clients registered as such with SEBI. These client accounts that the FII manages are known as ‘sub-accounts’. A domestic portfolio manager can also register itself as an FII to manage the. funds of sub-accounts

In order to act as a banker to the FIIs, the RBI has designated banks that are authorised to deal with them. The biggest source through which FIIs invest is the issuance of Participatory Notes (P-Notes), which are also known as Offshore Derivatives.

Insider Trading

Insider Trading has been all over the news lately. First it was Enron and WorldCom. Then even the apparently squeaky clean Martha Stewart got pulled in. So just what is Insider Trading? How can you avoid problems with it, even if you are not classified as an insider?

Insider trading isn’t fraud. In most cases those prosecuted never had contact with the alleged victims on the other side of their trades. Although the victims chose to trade without prompting, the legal issue is only whether the trade was based on inside information.
 
How it occurs ?

Insider trading occurs (1) when an insider to a company, such as an officer or someone who owns a large percentage of the company, trades the company's stock. This is legal and acceptable, as long as that person is not trading based upon non-public company information.

Insider trading also occurs (2) when anyone, including employees, trades using non-public company information. This is considered illegal.

The illegal kind of Insider Trading is the trading in a security (buying or selling a stock) based on material information that is not available to the general public. It is prohibited by the US Securities and Exchange Commission (SEC) because it is unfair and would destroy the securities markets by destroying investor confidence.

The law bizarrely affects only one-half of the trading equation. People make money by not trading as well as trading. But it is virtually impossible to prove that someone chose not to buy or sell stock because of a legally improper tip. So hundreds, maybe thousands, of people get away with insider “not trading” every year. Yet it isn’t obvious that the operation of the financial markets is impaired in any way.

If there is a problem in the market about insider trading, it’s that the market is biased by imposing criminal sanctions on only one side of the transaction. Inside information should lead roughly equal numbers of people to buy, sell and do nothing. The criminal law encourages people to do nothing. Whatever the impact, it isn’t likely to be more efficient markets.

Insider-trading laws deny markets important information. The recent financial crisis was caused in large part by inadequate information. People didn’t know the true value of mortgage-backed securities, leading to a financial house of cards that crashed down on federal agencies, investment houses, commercial banks and average investors.

The distinction between public and non-public information is legally decisive but economically unimportant. Perversely, the insider-trading laws seek to prevent people from trading on the most accurate and up-to-date information. The law seeks to force everyone to make today’s decisions based on yesterday’s data. It’s a genuinely stupid thing to do.

The only plausible argument for ensuring that everyone trades on inadequate and outdated information is “fairness.” The Securities and Exchange Commission’s Enforcement Director, Robert Khuzami, says insider-trading prosecutions are aimed at restoring “the level playing field that is fundamental to our capital markets.”

That is, just because your brother-in-law works at the accounting firm, you shouldn’t be able to buy or sell based on his disclosure of a client company’s dire financial straits until everyone knows it.

But Wall Street is built on metaphorical hillsides. The market is suffused with this sort of unfairness. Professional investors make money because of asymmetries of information. Someone working on Wall Street is almost always going to be better versed on financial issues than a casual investor. People make careers picking up hints and suggestions to use in trading.

However unfair it might seem to trade on inside information, it is unfair to no particular person.

Unless you committed fraud as part of the transaction, the person who bought your shares or sold his did so because he wanted to do so based on his information. Your “inside” information had no impact on his decision, especially in the impersonal markets through which most security transactions occur.

Acting on new information moves the market toward the right or “honest” price, as economist Donald J. Boudreaux puts it. Prosecuting people for insider trading slows the price-adjustment process. That means the price shock when the relevant news hits the market will be more abrupt and the losses will be greater for some people.

In some insider-trading cases there is a genuine victim: individuals or companies whose proprietary information was improperly disclosed. That should be punished, but as a civil offense based on the relevant contractual or fiduciary relationship. This kind of disclosure shouldn’t be of concern to the feds, let alone be an offense serious enough to justify wiretaps and mass arrests.

Yet the SEC employs sophisticated computer software to identify a few “suspicious” trades out of hundreds of millions of transactions. Agency enforcement chief Khuzami wants greater access to grand-jury information and greater power to pressure defendants to turn in their confederates.

Insider trading shouldn’t be a crime. There typically is no victim. To the contrary, most of us benefit when prices move more rapidly to the right level.

Unfortunately, prosecutors, regulators and politicians alike periodically demonize insider trading to justify their offices and budgets. But there is no reason to punish investors who trade on accurate information. In fact, that is precisely what the financial markets should encourage.

An Insider

A company insider is someone who has access to the important information about a company that affects its stock price or might influence investors decisions. This is called material information.

The company executives obviously have material information. The Vice President of Sales, for example, knows how much the company has sold and whether it will meet the estimates it has provided to investors. Others within the company also have material information. The accountant who prepares the sales forecast spreadsheet and the administrative assistant who types up the press release also are insiders.

A public company, if it is smart, limits the number of people who have access to material information and, therefore, are considered insiders. This is done for a couple of reasons. First, they want to limit the likelihood that anyone will "leak" the information. Second, being an insider means being subject to severe limits on when you can trade in the company stock, usually only the middle month of each quarter.

The company's senior management are insiders. So are some of the financial analysts. The top sales people usually also are insiders, although a regional sales manager who only sees his or her own region's results may not be one. The individuals in Investor Relations and/or Public Relations who prepare the public announcements also are insiders.

If the company is developing a new product that could be a big seller, the key people in the Research & Development team would also be considered insiders, provided the information they have is material, as defined above.

Other individuals who are not employees, but with whom the company needs to share material information, are also insiders. This list could include brokers, bankers, lawyers, etc.

Not An Insider

So does that mean you are not an insider unless you are on the company's management team, financial or development teams, or someone hired to handle the material information? In a word, "No".

The SEC includes in its definition of insiders those who have "temporary" or "constructive" access to the material information. If the President of a company tells you that the company's best hope for a breakthrough product isn't going to get regulatory approval, you are now every bit as much an insider as he is, with respect to that information. It is illegal for him to trade based on that knowledge before it becomes public knowledge. It is equally illegal for you to do so because you are now a "temporary insider". This remains true regardless of how many times the information is passed. If the president tells his barber, who tells her baby sitter, who tells her doctor, who tells you, the barber, baby sitter, doctor and you are all "temporary insiders".

Anyone who has material information is prohibited from trading, based on that knowledge, until the information is available to the general public. The US Supreme Court ruled recently, that this even applies to someone with no ties to the company. Possession of material information makes you an insider, even if you stole the information.

Employees Stock Option Plan

ESOP means Employee Stock Options. As the term signifies, ESOP is about ‘options’. Employee Stock Options or ESOP are generally given by most of the big companies in India, especially IT companies which are listed outside India to their employees

ESOP’s are Employee Stock Option Plans under which employees receive the right to purchase a certain number of shares in the company at a predetermined price, as a reward for their performance and also as motivation for employees to keep increasing their performance. Employees typically have to wait for a certain duration known as vesting period before they can exercise the right to purchase the shares. The main aim of giving such a plan to its employees is to give shares of the company to its employees at a discounted price to the market price at the time of exercise. Many companies (especially in the startup phase) have now started giving Employee Stock Options as this is beneficial to both the employer as well as the employee. ... read more on yourstory.com

If the market price of the stock is above the procurement price, the employee stands to gain by selling it off immediately. If however the price is below the agreed price level, the employee has the option to set aside his option and not exercise it.

ESOPs are nothing but “OPTIONS”, which are also in stock market in India (remember Future & Options?)

Let me tell you what Stock Options are in general. If a person has a Stock Option, he actually has a right to BUY a stock in future at a pre-decided price agreed at the time of giving those stock options. So in future whatever is the market price does not matter, you always have an option to buy it at the price which was agreed upon. In this case if market price of the stock is above the pre-decided price, then you can just exercise your options of buying the stock and instantly you will be in profit. If however, the current market price is less than the pre-decided price, then you choose not to exercise the stock option at all and nothing happens.

Let me give you an example. Let’s say that an employee joins a company on 1st Jan 2013. His company gives him 500 ESOPs with vesting period of 3 yrs and at the vesting price of Rs 200. What this means is that his vesting date is 1st Jan 2016 (after 3 yrs) , On that date, he has a OPTION to buy 500 stocks of the company at Rs 200 if he wishes. Now lets say on 1st Jan 2016 …

Case 1 – The stock price is Rs 800

In this case, the employee can exercise his option and he can get 500 stocks at only Rs 200 . At this moment, the employee will make a clean profit of Rs 600 each shares and a cool Rs 3,00,000 . Note that he does not have to pay anything here, when he exercises his option, he will automatically get his profit without putting anything from his pocket. It makes sense to exercise his option in this case, because vesting price is less than market price.

Case 2 – The stock price is Rs 130

In this case, it does not make any sense to exercise, because you will be in loss, because the price you have to pay is less than market price, so you let this option go.

Note : In case of stock options, you can never make any loss, it will always be some profit only.

Red Herring prospectus

The term red herring originates from the tradition whereby young hunting dogs in Britain were trained to follow a scent with the use of a "red" (salted and smoked) herring (see kipper). This pungent fish would be dragged across a trail until the puppy learned to follow the scent.

The reason it is called a red herring is due to a disclosure statement printed in red ink on the cover which explicitly states that the issuing company is not attempting to sell its shares. e.g. "A Registration Statement relating to these securities has been filed with the Securities and Exchange Commission but has not yet become effective. Information contained herein is subject to completion or amendment. These securities may not be sold nor may offers to buy be accepted prior to the time the Registration Statement becomes effective."

When a company decides to go public the company appoints underwriters and registrars of issue, it first involve one or more investment banks known as underwriters. The company and the investment bank first discuss some aspects like the amount of money a company will raise, the type of securities to be issued and all the details in the underwriting agreement. After the company secures an underwriter, it files a draft offer prospectus SEBI for review. 

This document contains information about the offering and company’s information like financial statements, management background, legal issues (if any), use of proceeds and risk factors. Once the draft document cleared by SEBI, it becomes offer document. Offer document is then submitted to registrar of the issue and stock exchange. Once offer document gets clearance from stock exchange, Issuer company makes it available to the public. The issue prospectus is now called as ‘Red Herring Prospectus’.

It means a prospectus which does not have complete details as regards the price at which the securities are being offered and the quantity of securities. When the offer of securities gets closed, then the company has to file a final prospectus stating therein the total capital or quantity of securities raised and the price of the securities or any other details which were not given in the red-herring prospectus. This final prospectus, in case of a listed public company, is necessary to be filed with the Securities and Exchange Board of India (SEBI) and the Registrar of Companies but if the company is not a listed one then the company has to file the final prospectus only with the Registrar of companies.

Red Herring Prospectus is a prospectus which does not have details of either price or number of shares being offered or the amount of issue. This means that in case price is not disclosed, the number of shares and the upper and lower price bands are disclosed.

On the other hand, an issuer can state the issue size and the number of shares are determined later. An RHP for and FPO can be filed with the RoC without the price band and the issuer, in such a case will notify the floor price or a price band by way of an advertisement one day prior to the opening of the issue. In the case of book-built issues, it is a process of price discovery and the price cannot be determined until the bidding process is completed.

Hence, such details are not shown in the Red Herring prospectus filed with ROC. Only on completion of the bidding process, the details of the final price are included in the offer document. The offer document filed thereafter with ROC is called a prospectus.