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Copyright © 2005 MoneyWhispers.com
Money Tips - One theory about equity price in professional
investment circles continues is the Efficient Markets Hypothesis (EFM),
although this theory is being widely discredited in the academic and
professional markets. Briefly, this theory suggests that the share prices of
equities are priced efficiently and will tend to follow a random walk
determined by the emergence of news (randomly) over time. Professional
equity investors therefore tend to spend their time immersed in the flow of
fundamental information seeking to gain an advantage over their competitors
(mainly other professional investors) by more intelligently interpreting the
emerging flow of information (news).
The EFM theory does not seem to give a complete description of the process
of equity price determination, for example because stock markets are more
volatile than a theory that assumes that prices are the result of
discounting expected future cash flows would imply. In recent years it has
come to be accepted that the share markets are not perfectly efficient,
perhaps especially in emerging markets or other markets where the degree of
professional (very well informed) activity is lacking.
Another theory of share price determination comes from the field of
Behavioral Finance. In Behavioral Finance, it is believed that humans often
make irrational decisions, particularly related to the buying and selling of
securities based upon fears and misperceptions of outcomes. The irrational
trading of securities can often create securities prices which vary from
rational, fundamental prices valuations. For instance, during the technology
bubble of the late 90's and subsequent 'burst' in 2000-2002, technology
companies were often bid beyond any rational fundamental value because of
what is commonly known as the 'greater fool theory'. The Greater Fool Theory
holds that because the predominant method of realizing returns in equity is
from the sale to another investor, one should select securities that they
believe that someone else will value at a higher level at some point in the
future. - from Wikipedia.org
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