Page 203 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes volume, is public information. Public information also includes all non-market information,
such as earnings and dividend announcements, price-to-earnings (P/E) ratios, dividend-yield
(D/P) ratios, price book value (P/BV) ratios, stock splits, news about the economy, and political
news. This hypothesis implies that investors who base their decisions on any important new
information after it is public should not derive above-average risk-adjusted profits from their
transactions, considering the cost of trading because the security price already reflects all such
new public information.
The strong-form EMH contends that stock prices fully reflect all information from public and
private sources. This means that no group of investors has monopolistic access to information
relevant to the formation of prices. Therefore, this hypothesis contends that no group of investors
should be able to consistently derive above-average risk-adjusted rates of return. The strong
form EMH encompasses both the weak form and the semi-strong form EMH. Further, the strong
form EMH extends the assumption of efficient markets, in which prices adjust rapidly to the
release of new public information, to assume perfect markets, in which all information is cost-
free and available to everyone at the same time. This unit contains five major sections. The first
discusses why we would expect capital markets to be efficient and the factors that contribute to
an efficient market where the prices of securities reflect available information. The efficient
market hypothesis has been divided into three sub-hypotheses to facilitate testing. The second
section describes these three sub-hypotheses and the implications of each of them. The third
section is the largest section because it contains a discussion of the results of numerous studies.
This review of the research reveals that a large body of evidence supports the EMH, but a
growing number of other studies do not support the hypotheses. In the fourth section, we
discuss the concept of behavioural finance, the studies that have been done in this area related to
efficient markets, and the conclusions as they relate to the EMH. The final section discusses what
these results imply for an investor who uses either technical analysis or fundamental analysis or
what they mean for a portfolio manager who has access to superior or inferior analysts. We
conclude with a brief discussion of the evidence for markets in foreign countries.

7.2 Efficient Frontier: (i) Risk-free and (ii) Risky Lending
and Borrowing

We saw how the risk and return of investments may be characterized by measures of central
tendency and measures of variation, i.e. mean and standard deviation. In fact, statistics are the
foundations of modern finance, and virtually all the financial innovations of the past thirty
years, broadly termed “Modern Portfolio Theory,” have been based upon statistical models.
Because of this, it is useful to review what a statistic is, and how it relates to the investment
problem. In general, a statistic is a function that reduces a large amount of information to a small
amount. For instance, the average is a single number that summarizes the typical “location” of
a set of numbers. Statistics boil down a lot of information to a few useful numbers and as such,
they ignore a great deal. Before the advent of the modern portfolio theory, the decision about
whether to include a security in a portfolio was based principally upon fundamental analysis of
the firm, its financial statements and its dividend policy. Finance professor Harry Markowitz
began a revolution by suggesting that the value of a security to an investor might best be
evaluated by its mean, its standard deviation, and its correlation to other securities in the
portfolio. This audacious suggestion amounted to ignoring a lot of information about the firm,
its earnings, its dividend policy, its capital structure, its market, its competitors and calculating
a few simple statistics. In this unit, we will follow Markowitz’s lead and see where the technology
of modern portfolio theory takes us.

1. The Risk and Return of Securities: Markowitz’s great insight was that the relevant
information about securities could be summarized by three measures: the mean return
(taken as the arithmetic mean), the standard deviation of the returns and the correlation

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