Answer a)
Market is said to be efficient when the same amount of information is available to all investors at the same amount of time. In other words, an ‘Informational Efficient Market’ is said to be efficient Nobel Laureate, Eugene Fama was the strong proposer that the market is efficient, i.e. , since similar amount of information Is available to all the investors at same amount of time, all the stocks in the market are perfectly priced and no investor can beat the market returns.
However, whether the stock markets are efficient or not, the topic is still in debate despite of almost half a century since its origin. The major section of financial academicians and researchers propose the idea that the stock market is not efficient because of the following problems:
- The Efficient Market Hypothesis (EMH) assumes that all the investors perceive same amount of information in a similar manner. However, in reality, every investor analyzes the stock prices with his own objective. For Instance, if an investor is looking for an under-valued security and other is looking for stocks with growth potential, both the investor will arrive at different fair stock price. Thus, our clarification, clearly contradicts with the idea of informational efficient stock market assumption of EMH.
- Another assumption of EMH is that no single investor will ever be able to earn higher profitability than the other investor is they both have an equal amount of stocks. However, we all are aware of the whole range of investment universe and billions of investors earning different returns. For Instance, where Warren Buffet is a proud owner of $53 Billion net worth, many investors have lost and are still losing their invested funds. In short, EMH believes that if one investor is profitable, other should also be, but in reality, this is not possible, and it never happens.
- Final assumption of EMH, which discards the idea that the markets are efficient, is that EMH asserts that since every investor has a similar amount of information, no investor should be able to beat the market. However, there have been many instances where investors or analyst have successfully beaten the market returns with their stock-picking ability.
Thus, in conclusion, we can say that, No, the stock markets are not efficient. However, with growing innovations in the high-speed computers and applications that pick stocks on their own, we can believe that we are heading toward an efficient market but as of now there is no complete efficiency in stock markets. But, since, in the end, it will always be human who will execute stock pick decisions, the possibility of human error may always keep the stock market below perfection. For a market to achieve perfect efficiency, the following criteria must be met:
1) Universal common access to some high speed and high technical systems of pricing analysis.
2) Removing human emotions from the stock-picking decisions.
Answer b)
Now we have come to know about the inefficiency of market efficiency, we have to be very cautious while making investment decisions for our retirement. Assuming I am risk averse investor and do not want to be exposed to high amount of risk levels and also my preference goes to wide exposure of my portfolio to a number of asset classes, it will be appropriate to follow, Moderately Conservative Investment Strategy.
Before deciding upon the weight allocation to different asset classes for Moderately Conservative Strategy, it is important to discuss what a moderately conservative investor desires. Most of the investor under this investment strategy are either near to retirement or have already suffered losses from their past investments. Thus, such kind of investors prefers to stay on low risk horizon, but at the same time, they desire of achieving double-digit return when market is in bullish trends. Thus, their investment objective is thus achieved by exposing their portfolio to the number of asset classes, which includes, fixed income securities, Core-Equity asset classes, commodities and derivatives that primarily track inflation and index based mutual funds.
Rationale for Weights of Asset Classes:
Fixed Assets:
High percentage of portfolio composition is allocated to Fixed Income Securities as Bonds and Notes. An individual, who is planning for his retirement, prefers to invest in 5-10 Year maturity products with guaranteed 4-5% annual compounded return on their portfolio. Furthermore, treasury bonds will be preferred as these are high rated fixed securities and the investor can be relieved with major portion of his asset allocation into secured investment instruments.
Equity Stocks:
Second high allocation will be channelized in Equity Stocks that will amount to 25% of the total portfolio composition. However, only core-equity classes will be considered, and no investment will be made in high risk class equities.
Mutual Funds:
This is one of the most preferred sources of investment for the retirees as Mutual Funds have the characteristic of Equity Based Return and Fixed Income Based safety. 15% allocation to Debt+ Equity Based Mutual Funds will be appropriate.
Derivatives:
For a moderately conservative investor, 15% allocation to the inflation-tracking hybrid securities will be appropriate as this will help him to hedge inflation risk at the time of retirement to a certain extent.
Works Cited
Bergen, J. V. (2011, January 9). Efficient Market Hypothesis: Is The Stock Market Efficient? Retrieved March 18, 2014, from Investopedia: http://www.investopedia.com/articles/basics/04/022004.asp
The Five Most Commonly-used Investment Risk Tolerance Categories. (n.d.). Retrieved March 15, 2014, from Toolsformoeny.com: http://www.toolsformoney.com/investment_risk_tolerance.htm
