Investment Theory and Strategies
Investment Theory and Strategies
A. Passive vs. Active Strategy
i.
Passive
One of the most profound ideas affecting the investment decision process, and indeed all of finance, is the idea that the securities markets, particularly the equity markets, are efficient. In an efficient market, the prices of securities do not depart for any length of time from the justified economic values that investors calculate for them. Economic values for securities are determined by investor expectations about earnings, risks, and so on, as investors grapple with the uncertain future. If the market price of a security does depart from its estimated economic value, investors act to bring the two values together. Thus, as new information arrives in an efficient marketplace, causing a revision in the estimated economic value of a security, its price adjusts to this information quickly and, on balance, correctly. In other words, securities are efficiently priced on a continuous basis.
An efficient market does not have to be perfectly efficient to have a profound impact on investors. All that is required is that the market be economically efficient. That is, after acting on information to trade securities and subtracting all costs (transaction costs and taxes, to name two), the investor would have been as well off with a simply buy-and-hold strategy. If the market is economically efficient, securities could depart somewhat from their economic (justified) values, but it would not pay investors to take advantage of these small discrepancies.
A natural outcome of a belief in efficient markets is to employ some type of passive strategy in owning and managing common stocks. If the market is totally efficient, no active strategy should be able to beat the market on a risk-adjusted basis. The
Efficient Market Hypothesis has implications for fundamental analysis and technical analysis, both of which are active strategies for selecting common stocks.
Passive strategies do not seek to outperform
A. Passive vs. Active Strategy
i.
Passive
One of the most profound ideas affecting the investment decision process, and indeed all of finance, is the idea that the securities markets, particularly the equity markets, are efficient. In an efficient market, the prices of securities do not depart for any length of time from the justified economic values that investors calculate for them. Economic values for securities are determined by investor expectations about earnings, risks, and so on, as investors grapple with the uncertain future. If the market price of a security does depart from its estimated economic value, investors act to bring the two values together. Thus, as new information arrives in an efficient marketplace, causing a revision in the estimated economic value of a security, its price adjusts to this information quickly and, on balance, correctly. In other words, securities are efficiently priced on a continuous basis.
An efficient market does not have to be perfectly efficient to have a profound impact on investors. All that is required is that the market be economically efficient. That is, after acting on information to trade securities and subtracting all costs (transaction costs and taxes, to name two), the investor would have been as well off with a simply buy-and-hold strategy. If the market is economically efficient, securities could depart somewhat from their economic (justified) values, but it would not pay investors to take advantage of these small discrepancies.
A natural outcome of a belief in efficient markets is to employ some type of passive strategy in owning and managing common stocks. If the market is totally efficient, no active strategy should be able to beat the market on a risk-adjusted basis. The
Efficient Market Hypothesis has implications for fundamental analysis and technical analysis, both of which are active strategies for selecting common stocks.
Passive strategies do not seek to outperform