Question

Many professionals regard the equity markets to be a bit like Las Vegas. That is, it's possible to win big if you take high risks, but the odds are in favor of the casinos. In the case of the equity markets, it's possible to beat the stock index funds if you take the risks, but the odds are against it.

1) Explain the concept of efficient markets. Are the equity capital markets inefficient?

2) What is the role of accounting in an efficient market?

3) Is it worth investing the time and money to beat the market? Does it help to conduct financial statement analysis? Should you time the markets?

Answer 1

1) Efficient markets:

The efficient-market hypothesis (EMH) is a hypothesis in financial economics that states that asset prices 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.

The concept of an efficient market is ambiguous. A market is neither strictly efficient nor strictly inefficient. The question is one of degree; one way to measure the efficiency of the market is to ascertain what type of information, encompassed by the total set of all available information, is reflected in security prices.

Refers to the degree to which market prices reflect all available, relevant information. If markets are efficient, then all information is already incorporated into prices, and so there is no way to "beat" the market because there are no undervalued or overvalued securities available.

KEY TAKEAWAYS

• The efficient market hypothesis (EMH) or theory states that share prices reflect all information.
• The EMH hypothesizes that stocks trade at their fair market value on exchanges.
• Proponents of EMH posit that investors benefit from investing in a low-cost, passive portfolio.
• Opponents of EMH believe that it is possible to beat the market and that stocks can deviate from their fair market values.

An Equity Capital Market is a market between "companies and financial institutions" that is aimed at earning money for the company. Examples of financial institutions involved include Goldman Sachs and Citigroup.

The Equity Capital Markets are efficient,  The primary role of the capital market is the efficient allocation of the economy's capital stock. In general terms, the goal of any economy is growth of a market in which prices provide accurate signals for resource allocation, that is, a market in which firms can undertake production and investment decisions while investors can choose among the securities that represent ownership of firms' activities under the assumption that security prices at any time 'fully reflect' all available information.^ Efficient security pricing is, therefore, tantamount to efficient fund allocation by an efficient (security) market. Hence a market in which prices always 'fully reflect' all available information is called' efficient.

2) Role of accounting in an efficient market:

Accounting is an important controlling tool in developed economics. Accounting society has well passed these tests of applying financial controls. Development of capital market depends on not manipulated prices system, not pretermitted transparency and reliable information in an efficient market.

Much of capital market research in accounting over the past 20 years has assumed that the price adjustment process to information is instantaneous and/or trivial. This basic assumption has had an enormous influence on the way we select research topics, design empirical tests, and interpret research findings. In this discussion, I argue that price discovery is a complex process, deserving of more attention. I highlight significant problems associated with a naïve view of market efficiency, and advocate a more general model involving noise traders. Finally, I discuss the implications of recent evidence against market efficiency for future capital market research in accounting.

I believe accountants have a role to play in understanding noise trader demand. Unlike Keynes’ animal spirits, Shiller’s noise traders are not driven primarily by idiosyncratic impulses or “a spontaneous urge to action” (Keynes (1936, page161)). Instead, the mistakes in investor expectations are correlated across traders. Thus, Shiller does not model individual irrationality so much as mass psychology or clientele effects. Much of accounting is historical in nature. A good deal of our research in the capital market area has also tended to be retrospective. Much of the marketbased research discussed in Kothari (2000) has been conducted within a framework where stock return (or price) appears as the dependent variable and contemporaneous accounting data appear as independent variables. According to this widely accepted paradigm, accounting data that better explain contemporaneous return (or price) are presumed to be superior in some normative sense.

Mainstream accounting and economic thought is shaped by classical information economics - the study of normative behavior under full rationality assumptions. While this powerful paradigm has proved instructive, it has also engendered an unfortunate tendency to attribute unlimited processing ability to decision makers. I regard this tendency as unfortunate, because it inhibits the development of potentially promising avenues of research. In the area of capital market research, this literature has produced a deep-seated faith in market efficiency that, for many years, detracted from potentially fruitful inquisitions along alternative paths. As economists, we tend to take for granted the efficacy of the arbitrage mechanism, generally assuming that it involves no capital, and little cost or risk. Steeped in equilibrium analysis, mainstream economics offer virtually no guidance on the dynamic process of information aggregation. The market price is assumed to be correct, as if by fiat, and the process by which it becomes correct is trivialized. I believe accounting academics working in the capital market area should not assume away the process by which price assimilates information.

3) Yes, you may be able to beat the market, but with investment fees, taxes, and human emotion working against you, you're more likely to do so through luck than skill. If you can merely match the S&P 500, minus a small fee, you'll be doing better than most investors.

The phrase "beating the market" means earning an investment return that exceeds the performance of the Standard & Poor's 500 index. Commonly called the S&P 500, it's one of the most popular benchmarks of the overall U.S. stock market performance. Everybody tries to do beat it, but few succeed.

The Barriers

Investment fees are one major barrier to beating the market. If you take the popular advice to invest in an S&P 500 index fund rather than on individual stocks, your fund's performance should be identical to the performance of the S&P 500, for better or worse. But investment fees will be subtracted from those returns, so you won't quite match it, never mind beat it. Look for index funds with ultra-low fees of 0.05% to 0.2% a year, and you'll get close to equaling the market, though you won't beat it.

Taxes are another major barrier to beating the market. When you pay tax on your investment returns, you lose a significant percentage of your profit. For 2018, the capital gains tax rate is 15% to 20%, unless your income is very low. And that's the tax on investments held for at least one year. Stocks held for a shorter-term are taxed as ordinary income.

Investor psychology presents a third barrier to beating the market. Perversely, most people have a tendency to buy high and sell low because they're inclined to buy when the market is performing well and sell out of fear when the market starts to drop. This one at least is within your control. Learn how to analyze a stock and consider the company's potential for future gains. It's not foolproof, but at least you'll be buying for sound reasons.

Risk Is Key

One way to try to beat the market is to take on more risk, but while greater risk can bring greater returns it can also bring greater losses. You might also be able to outperform the market if you have superior information. There are few ways that an individual investor can possess superior information unless they are company insiders, and trading on nonpublic information is a serious crime called insider trading. Defined more broadly, though, you may have superior information based on your expertise in an industry or a product. There's no crime in investing in what you know.

Some investors have made fortunes through what appear to be superior analytical skills. Household names like Peter Lynch and Warren Buffett achieved their successes by picking individual stocks. Many individuals you've never heard of have attempted similar strategies and failed. Even most professional mutual fund managers can't beat the market.

Sometimes It's Just Luck

Meaning no disrespect, Lynch and Buffett may have just been exceptionally lucky, even if they are financial whizzes. Highly regarded economists have shown that a portfolio of randomly chosen stocks can perform as well as a carefully assembled one.

We examine whether investors can exploit financial statement information to identify companies with a greater likelihood of future earnings increases and whether stocks of those companies generate 1-year abnormal returns that exceed the abnormal returns from following analysts’ consensus recommendations. Our approach summarizes financial statement information into a “predicted earnings increase score,” which captures the likelihood of 1-year-ahead earnings increases. We find that, within our sample of consensus recommendations, stocks with high scores are much more likely to experience future earnings increases than stocks with low scores. A hedge portfolio strategy that utilizes our approach within each consensus recommendation level generates average annual abnormal returns of 10.9 percent over our 12-year sample period, after controlling for previously identified risk factors. These abnormal returns exceed those available from following analysts’ consensus recommendations. Our results show that share prices and consensus recommendations fail to impound financial statement information that helps predict future earnings changes. Keywords Earnings predictions–Financial statement analysis–Consensus recommendations–Abnormal returns–Sell side analysts.

In today's global world when the markets are more connected than ever before the information about the financial position and performance of the companies is becoming more important. If the capital providers want to choose into which company they should invest their resources, they need to compare the contemporary financial position and performance of selected companies and try to forecast their future development.

Common wisdom today tells us that timing the market doesn't work. As hard as investors may try, earning massive profits by timing buy and sell orders around future market price movements is an elusive concept. However, some investors can still profit from timing the market in a smaller, more reactionary way.

The Best Way to Time the Stock Market

However, stock market crashes are all but impossible to predict even for the most informed investors. ... Timing the market in this manner – predicting gains after a crash rather than predicting the crash itself – is the most effective way to time the market.