1. Random walk theory
In the Fundamental Analysis, factors such as economic influences, industry factors, and particular company information are considered to form a judgment on share value. On the other hand, price and volume information is analyzed in Technical Analysis to predict the future course of share values. There is another approach that negates both Fundamental and Technical analysis. This approach has been based upon the research aimed at testing whether successive price changes are independent in different forms of market efficiency.
According to the theory, share prices will rise and fall on the whims and fancies of manipulative individuals. As such, the movement in share values is absolutely random and there is no need to study the trends and movements prior to making investment decisions. No sure prediction can be made for further movement or trend of share prices based on the given prices at a particular moment. The Random Walk Theory is inconsistent with technical analysis. Whereas it states that successive price changes are independent, the technicians claim that they are dependent. But believing in the random walk does not mean that one should not believe in analyzing stocks. The random walk hypothesis is entirely consistent with an upward and downward movement in price, as the hypothesis supports fundamental analysis and certainly does not attack it.
2. Efficient – Market Theory
Efficient Market Hypothesis accords supremacy to market forces. A market is treated as efficient when all known information is immediately discounted by all investors and reflected in share prices. In such a situation, the only price changes that occur are those resulting from new information. Since new information is generated on a random basis, the subsequent price changes also happen on a random basis. Major requirements for an efficient securities market are:
– Prices must be efficient so that new inventions and better products will cause a firms’ securities prices to rise and motivate investors to buy the stocks.
– Information must be discussed freely and quickly across the nations so that all investors can react to the new information.
– Transaction costs such as brokerage on sale and purchase of securities are ignored.
– Taxes are assumed to have no noticeable effect on investment policy.
– Every investor has similar access to investible funds at the same terms and conditions.
– Investors are rational and make investments in the securities providing maximum yield.
(a) The Strong Form of Efficiency: This test is concerned with whether two sets of individuals – one having inside information about the company and the other uninformed could generate a random effect in price movement. The strong form holds that the prices reflect all information that is known. It contemplates that even the corporate officials cannot benefit from the inside information of the company. The market is not only efficient but also perfect. The findings are that very few and negligible people are in such a privileged position to have inside information and may make above-average gains but they do not affect the normal functioning of the market.
(b) Semi-strong form of Efficiency: This hypothesis holds that security prices adjust rapidly to all publicly available information such as functional statements and reports and investment advisory reports, etc. All publicly available information, whether good or bad is fully reflected in security prices. The buyers and sellers will raise the price as soon as a favorable price of information is made available to the public; the opposite will happen in case of an unfavorable piece of information. The reaction is almost instantaneous, thus, printing to the greater efficiency of the securities market.
(c) The Weak Form theory: This theory is an extension of the random walk theory. According to it, the current stock values fully reflect all the historical information. If this form is assumed to be correct, then both Fundamental and Technical Analysis lose their relevance. A study of the historical sequence of prices, can neither assist the investment analysts or investors to abnormally enhance their investment return nor improve their ability to select stocks. It means that knowledge of past patterns of stock prices does not aid investors to make a better choice. The theory states that stock prices exhibit random behavior.