Ideal investment practices in an efficient market

Efficient market is a theory in financial economics which, according to wikipedia, ascertains that asset prices fully reflect all available information.

A direct implication is that it is impossible to “beat the market” consistently on a risk-adjusted basis since market prices should only react to new information

EMH consists of a weak form (stock prices reflect all information), semi strong form (stock price already reflects all publicly available information), and a strong form (current market prices reflect all information, whether publicly available or privately held).

The Efficient Market Hypothesis, according to investopedia, contends that the stock market is efficient, meaning that all current public information about companies is completely and accurately reflected in their share price. Stronger forms of the EMH exist, extending the claims of efficient information processing to new information, and even non-public information.

The important thrust of the EMH is that investors cannot beat the market because stock prices accurately reflect reality. There is thus no opportunity for arbitrage and no hidden opportunity to exploit.

If true, successful value investing ought to be impossible, since there are no truly undervalued stocks to find. Growth stock investors and traders would fair no better, since any growth potential that a bustling company might have will be priced in already

Portfolio rebalancing

Over the long term, stocks generally rise faster than bonds, so the stock portion of your portfolio will likely go up relative to the bond portion, except when you rebalance the portfolio to target the original allocation.

The difference between the target allocation of one’s portfolio and the actual weights in one’s current portfolio is called portfolio drift.

A high drift may expose you to more risk than you intended when you set the target allocation and much of that risk may be uncompensated meaning that the portfolio hasn’t targeted higher expected returns by taking on the additional risk.

Implementing actions to reduce this drift is called rebalancing albeit keeping the same portfolio strategy over years is a challenge in its own right. Even without active changes to your portfolio, its structure will drift over time.

This is due to market movements of the single portfolio positions. It can cause a major misalignment of your originally planned strategic asset allocation. Positions with strong gains will proportionally be sold and positions which have lost in value will proportionally be bought. This will bring your portfolio back to your original asset allocation

Long term investors may try to manage risk by periodically selling stock investments or asset classes that seemingly take up too much of their portfolios. They will sell off those assets and buy more of the stocks or that have underperformed. This can be a forced means of buying low and selling high.

Diversification

Diversification reduces risk as more shares or assets are held in a portfolio. However, it is impossible to eliminate all risk completely even with extensive diversification. The risk that remains is called market risk; the risk that is caused by general market influences.

This risk is also known as systematic risk or non-diversifiable risk. The risk that is associated with a specific asset and that can be abolished with diversification is known as unsystematic risk, unique risk or diversifiable risk. As the number of assets in a portfolio increases, the total risk may decline as a result of the decline in the unsystematic risk in that portfolio.

The idea behind investment diversification, in an article published by moneycrashers.com, is to buy asset classes or sectors that are not correlated. That means that if one goes up, the other is probably going down.

Diversification has been a lot more difficult to achieve over the past few years as many asset classes have become highly correlated. Even stocks and bonds have been moving in the same direction much more often than in the past.

Diversification is a good strategy to limit your risk, but it only works if the assets you buy are truly uncorrelated. Also you can diversify on a global basis to eliminate all unsystematic risk.

Passive Portfolio Management

Passive asset management relies on the fact that markets are efficient and it is not possible to beat the market returns regularly over time and best returns are obtained from the low cost investments kept for the long term.

The passive management approach of the portfolio management involves Indexing, which is a portfolio selection strategy. According to this theory, the index funds are used for taking the advantages of efficient market theory and for creating a portfolio that impersonate a specific index.

The index funds can proffer benefits over the actively managed funds because they have lower than average expense ratios and transaction costs.

Passive management is not completely passive because unless the investor is purchasing shares of an index fund, he or she must actively select the securities in which to invest.

Passive management commonly relies on fundamental analyses of the company behind a security, such as the company’s long-term growth strategy, the quality of its products, or the company’s relationships with management when deciding whether to buy or sell.

However, short-term fluctuations, business cycles, inflation, and responses to new legislation do not influence passive managers.

Active Portfolio Management

Active portfolio management can outperform a passive index tracking strategy consistently over time if markets are a weak form efficient but not semi strong efficient

The weak form EMH includes all current market data and therefore technical analysis will not produce extra return. However, it does not include all publicly available information. Therefore, under weak form EMH you can achieve superior returns by undertaking fundamental analysis.

However, semi-strong EMH says that prices adjust rapidly to all publicly available information. Thus, fundamental active management will not produce superior returns and as such should implement a passive approach.

It might not explicitly say that active management can outperform under weak EMH but you can infer that it does by the rules of weak and semi strong EMH.

Determine and quantify clients’ Risk Preference.

Portfolio manager (or investor) who does not have access to superior analysts should proceed as follows. First, he or she should measure the risk preferences of his or her clients, and then build a portfolio to match this risk level by investing a certain proportion of the portfolio in risky assets and the rest in a risk-free asset.

If the client is risk averse you minimize risk while maximising returns since risk adverse clients are more concerned about losses more than returns.

After identifying risk preference of the client you should minimize transaction costs. Assuming that the portfolio is completely diversified and is structured for the desired risk level, excessive transaction costs that do not generate added returns will detract from your expected rate of returns.

Blessing Nyatanga holds a Bachelor’s Degree in Banking and Investment Management from NUST.0784909184/blessnyatanga@gmail.com-ebusinessweekly