Wednesday, 25 January 2012

Value Investing and Efficient Market Hypothesis

Value investing negates the concept of efficient market hypothesis and there are various reasons why many stocks trade away from their intrinsic values. People invest unreasonably based on psychological biases rather than backed by fundamental analysis. They buy when the price of share starts increasing or the stock market appears to be rising because they do not want to miss the profits what others might be achieving. Likewise, they sell when the share price or market as a whole starts declining, as they are afraid of uncertainty. They would like to accept small losses and leave their positions before it makes any more losses, such behavior is so extensive that it actually pushes the market movement down along with shares.

When market momentum or the herd mentality reaches its dangerous level, it causes the markets to crash. The tech and housing bubble are such examples where overinvestments pushed the price way above their actual worth, and when unjustifiable highs began to fall investors panicked and resulted in crash. The prices then pulled back to their intrinsic levels and even lower than that. Another common reason is that there are many small cap stocks, which does not get the attention that they deserve. It is because that they are not in headlines or are not household names but offering great potential. Similar to this, every investor wants to have the next big thing or the most glamorous stocks in the market like Apple (NASDAQ: AAPL), Google (NASDAQ: GOOG), and Microsoft (NASDAQ: MSFT), which are more sensitive to herd mentality than other small/mid cap stocks. And in such course inglorious companies might sell less than their true values.

Another major and most regular factor is the effect of bad news or announcements. Even good companies are exposed to the risk litigation or recalls but that does not mean the company is not fundamentally strong or prices will not bounce back. In such cases, investors overreact on the information, pave way for value investors to make long-term positions who believe in company’s strong fundamentals, and think that company can recover to a profitable venture again. Another case of over sensitivity is seen when company reports earnings less than what analysts have predicted. Investors overreact largely on such reports and forget that every analyst has different forecasting techniques and many have a poor history of predicting the future. Such irrational moves often cause the prices to drop momentarily. Such situations creates opportunity for value investors to make positions as stock prices get down even if the company keeps on creating value for its shareholders.

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