CFA Level 1
Securities Markets - Implications of Efficient Markets
EMH and Technical Analysis
Technical analysis bases decisions on past results. EMH, however, believes past results cannot be used to outperform the market. As a result, EMH negates the use of technical analysis as a means to generate investment returns.
With respect to fundamental analysis, the EMH also states that all publicly available information is reflected in security prices and as such, abnormal returns are not achievable through the use of this information. This negates the use of fundamental analysis as a means to generate investment returns.
EMH and the Portfolio Management Process
As we have discussed, the portfolio management process begins with an investment policy statement, including an investor's objectives and constraints. Given EMH, the portfolio management process should thus, not focus on achieving above-average returns for the investor. The portfolio management process should focus purely on risks given that above average returns are not achievable.
A portfolio manager's goal is to outperform a specific benchmark with specific investment ideas. The EMH implies that this goal is unachievable. A portfolio manager should not be able to achieve above average returns.
Why Invest in Index Funds?
Given the discussion on the EMH, the overall assumption is that no investor is able to generate an abnormal return in the market. If that is the case, an investor can expect to make a return equal to the market return. An investor should thus focus on the minimizing his costs to invest. To achieve a market rate of return, diversification in a numerous amounts of stocks is required, which may not be an option for a smaller investor. As such, an index fund would be the most appropriate investment vehicle, allowing the investor to achieve the market rate of return in a cost effective manner.
Within this section we have discussed the organization and function of securities markets, the composition and characteristics of the various weighting schemes, and the various implications of the efficient market hypothesis.