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THE SOUTH AFRICAN INDEX INVESTOR |
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“Greater rewards, lower costs” |
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TOOL BOX |
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Investment Philosophies, Theories and Practices (continued…)
Efficient Market Hypothesis
Three different versions of the Efficient Market theory exist which put some question marks over the efficacy of both technical and fundamental analysis. The theory is based on the “random walk” principle, which implies that stock prices vary in a random manner and it is impossible to predict future stock prices from historical price changes.
The weak version of the theory implies that one cannot predict future stock prices from past prices; basically contradicting technical analysis. The semi-strong version states that one cannot predict future prices since current stock prices reflect all publicly available information. Thus, one is unlikely to outperform the market portfolio by using only public information. The strong version rejects even fundamental analysis. Future prices cannot be predicted even if all information - public and confidential - of companies was known.
From a practical stance it is quite obvious that none of these versions is absolutely correct, but neither are they totally wrong. Markets in general are very efficient, but quite often pockets of opportunity exist which investors can exploit. For example, small cap stock is often not that well researched or followed as opposed to large cap stock. Second, some investors do score big with confidential information, even if strong measures are in place to prevent insider trading. Besides these fraudulent tactics, some investors through careful analysis and research do discover real gems which the market do not value at the time. Third, the market does experience from time to time exuberant price levels only to be followed by some hard landing. Thus, the market is definitely not always fitting the model of an efficient market as some academics might claim it to be.
Contrarian Investment Philosophies
An ideal investment philosophy for those who like to challenge conventional thinking! For example, while the consensus view might dictate that one should overweight certain stocks/sectors of the market, the contrarian would challenge this view and rather seek opportunities in those stocks/sectors that are neglected.
Contrarians do not risk their money by following the crowd, because more often than not it acts without reason. When the invalidity of crowd behaviour becomes apparent, a sharp turnaround in stock prices normally occurs – very often dipping to extreme lows (remember how dramatically technology and telecom stock prices fell in the early 2000s). At this point contrarian investors will pick up those stocks, at nothing less than absolute bargain prices.
Needless to say it is a wonderful strategy to follow, but extremely difficult to put into practice. Why? The expected turnaround might take much longer than anticipated and in the interim you may become anxious that you are missing out on making big money like your fellow investors that are going with the flow.
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