Inefficiency Within a Stock Market Create Barrier to Fulfilment of its Main Function - Assignment Example

?Inefficiency within a stock market create barrier to fulfilment of its main function & hence can cause significant difficulties for managers making corporate decisions. Table of Contents Table of Contents 2 Introduction 2 Stock Market Efficiency 3 Reasons of the Inefficient Stock Market 4 Effects of the Inefficient Stock Market 5 Conclusion 8 Reference 9 Introduction A stock market can be said efficient if the market reflects all the information available to all the investors. If the market is efficient then all the investors would get profit from the stock market. But this doesn’t happen actually. The stock market is inefficient in the reality. This inefficiency creates the barrier to fulfil the main function of the market as well as it becomes tough for the managers of the firms to take the right decision. The main functions of the stock market includes evaluation of the securities those are listed in the stock market which in turn help the companies to get more capital for production, thus the chances of industrial growth increase. The functions of the stock market also includes the marketing of the government securities, also provide safety in the dealings as the companies have to abide by the rules. The stock market is also the index of the economy; the banks also provide loans against the stock market securities. From the above discussion the importance of the stock market can be understood. But when the stock market which is the economical indicator is not performing as it should be then it would be a problem for the community associated with that stock market. The common people who are the investors of the securities they would face problem as the stock market is not reflecting the right information, they may invest in the wrong place. The foreign investors and the government would not get the right information as the stock market is not efficient, not the actual information is available in the market. The managers of the firms also get it tough to take the right decision in the current situation. May be they are thinking that their firm is performing well but their firm is valued less in the stock market. So it will be tough for them to take the decision as they find it confusing as two different valuations of the firm are in front of them. The paper is an attempt to analyze the effect of the inefficient stock market, how it creates barrier to fulfil the main functions of the stock market and cause difficulties for the managers of the firms for taking a suitable decision. The researcher has taken the help of some theories like efficient market hypothesis and uses some articles for conducting the research. Stock Market Efficiency As per Professor Eugene F. Fama an efficient market fully reflect the information available to the investors. The research of Fama was divided in 3 parts on the basis of the information available. In the weak form of efficiency in the EHM claims that the past prices of the security are reflected in the price of the security today. No one can beat the market by doing the fundamental analysis. The semi strong form of tests implies that all the public information available reflects in the current market price of the stock, no one can beat the market by doing the fundamental analysis or the technical analysis. The other degree of efficiency is the strong form of efficiency which implies that even using the insider information the investor can’t have the advantage (Fama, 1970, p.399-412). The accepted view about the efficient market hypothesis is that when the information is available about a specific company then the information spread fast among the investors of the company and the investors take necessary steps in that situation and that information reflects in the price of the security. Practically an example can be given to describe the situation. A company is going to change the strategy of operations. The change may bring profitability for the company. In an efficient market the all the investors of the company get the information as soon as the information is available to the company insiders. The random walk concept is associated with the efficient market theory of Professor Fama. The random walk theory reflects that the stock price changes are independent of one another. The investors can’t predict the prices by doing the fundamental analysis and the technical analysis. The stocks usually take the unpredictable path, not depends on the historical price or the market. It means the investors can’t take such steps so that he can outperform the market. The price change of a stock in one single day reflects only the news available to the market on that day only; not the information of the day earlier (Malkiel, 2003, p. 4-6). Due to the financial downturns in the stock markets the financial economists started to critique the efficient market hypothesis theory. They have argued that the future price of the stocks is predictable on the basis of the historical price of the securities. The investor can do the fundamental analysis of the company that is the analysis of the past price of the company and the technical analysis of the company and subsequently take the decision about investing. Reasons of the Inefficient Stock Market In the actual scenario the stock market is not efficient. The investors can predict the return from a certain security by doing the technical analysis, fundamental analysis. Even all the information which should be available as per the concept of efficient market hypothesis those are not available in reality. The insider trading is possible in the practical world when the information is available to some investors only. It can also be happen that the available information to the market is not properly informed to some investors. Based on the information the investors take the decisions, and the stock market moves as per the decision taken by them. The behavioural economists place greater importance on the human behaviour for the imperfection of the stock market. The economists have argued that the deviation of the judgement occurs based on the decision of the individuals. This is called as cognitive biases by the economists. The reason of the inefficient markets has been provided by the economists. One reason is under reaction. When information is available to the market then may be the investors then the reaction of the investors may be different. Some investors may think that it would be the intellectual step to go conservatively. These individuals prefer to slowly adjust to the situation. When some investors prefer to react conservatively then the security price would not reflect the actual price that should be in the situation. As the stock market is the index of the economy and it doesn’t reflect the actual price of the securities then it would be tough for the stakeholders to take the decision about the company, may be they would take the wrong decision. Another reason of the inefficient market can be the overreaction. There may be a situation when the investors formulate a strategy for investing in the stock market. But in some situation when some new information is available in the market, they should change their strategy according to the information available to them. But due to their overconfidence and the reaction of the noise traders the security price started to overreacted. For example if some positive information is available to the investors then the stock price of the company should increase but due to the overconfidence and the reaction of the noise traders the price of the securities increase more than anticipated price. There are two types of traders in the market, information traders and the noise traders. The information traders are they who used to take decision on the basis of the information available to them. The noise traders are the traders whose decision don’t based on any rational parameter. Information pricing error can happen when the information traders also behave like the noise traders. Their decision based on the decision of the noise traders (Bruce, 2010, p.381-382). Effects of the Inefficient Stock Market The stock market is the economical index of a country. The main function of the stock market is that the companies which are listed in the stock market get necessary capital from the investors. The stock market behaves as the retail outlet where the buying and selling of the securities can take place. From the current price of the securities listed in the market the investors and the other interested parties of the company like the company management can get an idea about the security evaluation. The performance of the securities interests various parties for various reasons. The government are interested for the performance of the securities as they can forecast about the country’s economy based on the performance of the key companies. The investors are interested about the performance of the stocks as they have to take further decision based on the price of the securities. If the stock price of a company is decreasing then it implicates that the performance of the company is not good and then they may take the decision to sell the stocks. When they found that the company is performing good in the stock market then their investment increase the probability of their return as well as the possibility of the profitability of the company also increase. The investors can have the bank loan against the securities holding by them. The company management is also interested for the performance of the stock in the security market. They can understand the investors’ perception about the company through the price of the stock in the stock market. As a result they can take necessary step that is they can change the strategies so that the company can attract more investors as they are the source of capital which would generate more profitability for the companies. From the discussion it can be derived that the stock market performance of a company is important for the company management as well as the investors. The government of that country is interested about the performance of the stocks as this reflects the economic conditions of that country. But in an inefficient market the stock performance doesn’t reflect all the information available to the market. The stock is not rightly priced, may be it overpriced or underpriced. When the price of the stock is overpriced or underpriced, then the investor may think that it is the right value of the stock and based upon this the person take the decision. So in the inefficient market by these decisions the investors may get hampered financially. The effects of the inefficient market have been clear in the United Kingdom market. The merchant bankers, who were called as the aristocrats of the financial system wiped out because of the operation of the investment banks of U.S as they were more aggressive. The investment banking industry of United Kingdom also has faced strong competition from the U.S. based investment banking industry and they have failed to sustain in the competition. The financial services industry has to face all these things due to the inefficiency of the market (Kay, 2011). Because of inefficiency in the financial markets where the investors react differently to specific information, the stock price doesn’t reflect the actual condition of the company. Financial crisis happens because of the decrement of capital inflow in the stock market. When some investors book their profit from certain securities based on some available information then it creates negative impact in the mass. Because of information cascade all the other investors think negatively. They also divest those securities from their portfolio. Even based on some information about the market as a whole (like some economical policies announced by the government) more than one securities can get hampered. The risk taking strategy of the European Union is also the cause of the financial crisis. Some investors become overconfident based on their and the stock’s past performance and some assumptions taken by them about the future of the stock (Kay, 2011). They should react to the latest available information, but they haven’t done so, instead they have taken the risk. These steps taken by the investors don’t reflect the correct price of a stock; also they can incur loss from these activities. These conditions can affect the security market as a whole. The financial crisis can take place in that country. In the era of globalization the financial crisis of one country can affect financial condition of some other country. The attitude of the investors can change towards the stock market. As they have seen the stock market is down in some other countries then they might think that the performance of the company can get hampered as the operations of the domestic companies are related with the overseas countries in some aspects. From the recent financial crisis it can be derived when the crisis take place then the banks was affected because of the large amount of bad debts of the company. It has also been seen that the governments has tried to restrict the financial crisis by injecting enough money but that was not sufficient. From this case it can be revealed that the governments are also affected by the financial crisis which is the result of the market inefficiencies. The inefficiency of the market which results in the financial crisis costs the government more. For supporting the economy government takes the burden of debts and deficits of the companies of private sector as it has been seen in case of America and United Kingdom during the recent financial crisis. When the government take the burden of the private companies then the credit rating of the companies go up as they don’t have the debt as the crisis period but the sovereign rating of the country goes down (Kay, 2011). Because the debt burden of the government increase and subsequently the rating agencies downgraded the rating. It has been seen that Standard and Poor has downgraded the rating of U.S.A. from AAA to AA+ (Mackenzie, 2011). The economical condition of a country also can affect the economical condition of some other country. It has been seen in the case of Greece debt crisis. As a result of the recent economic crisis of Greece the Euro zone countries also faced economical problem. The common currency of Euro zone is Euro. Because of the economic downturn of Greece other countries have to look after that the currency is not get downgraded which hampers their economy. The International Monetary Fund has periodically provided money to Greece, despite of that Greece is unable to come out from the situation. It is a fact that the money which is provided by IMF is the money of the taxpayers of the countries Euro zone (Lachman, 2012). From this discussion it can be said the debt crisis of Greece which is the result of the inefficient stock market not only has affected the concerned country, but all the countries that have interest in the country’s economy. The managers of the firms also find it difficult to take decisions because of the inefficient stock market. When the company is performing well and despite of that the stock is undervalued then the managers are getting confused about the right decision. The upmarket jewellery maker Theo Fennell which has performed well but the stock is still undervalued (Keohane, 2012). From this case it can be derived that though the stock has performed well in the recent times but the stock price doesn’t reflect the actual situation because of the inefficient market. Considering the financial conditions of the country overall and the market price movement of the stock the managers of the corporations find it difficult to take the right decisions in that situation. May be the company is performing well and the stock price movement of the firm is not as expected, also the economic conditions of that country is not so good, then the managers find it difficult for taking the decisions. Conclusion From the above discussion it can be said the inefficiency in the stock market creates barrier to perform the main function of the stock market as well as it makes tough for the managers of the corporations making corporate decisions. The stock market can be said as efficient if the information about the market is available to all the investors. No one can beat the market based on the fundamental, technical analysis even the insider information. The market is known as perfect in that situation. But this doesn’t happen in reality because the investors react differently in respond to some specific information available to them. Some of them like to stay conservative; some would like to overreact in the situation. So the market becomes inefficient after all. Because of the inefficient market the investors, the government and the corporate find it difficult to take the decision. In this research paper the researcher has discussed that the recent economic conditions of the world is the result of the inefficient market. It has also been found that due to the inefficient market the countries may be affected by the economic conditions of some other country. Overall the inefficiency in the market hampers the financial condition of an individual, the decisions of the corporate managers and the global economy in this era of globalization. Reference Bruce, B. (2010). Handbook of Behavioral Finance. United Kingdom: Edward Elgar Publishing. Fama, E. (1970). Efficient Capital Markets: A Review of Theory and Empirical Work. Available at: http://gesd.free.fr/fama1970.pdf. [Accessed on: January 31, 2012]. Keohane, D. (2012). Small- Caps: Theo Fennell Tumbles on Sales Data. Available at: http://www.ft.com/intl/cms/s/0/c23d2180-3d43-11e1-b0e4-00144feabdc0.html#axzz1l1nEHAN1. [Accessed on: January 31, 2012]. Lachman, D. (2012). Misdiagnosis Has Made IMF Cavalier with Taxpayer Money. Available at: http://www.ft.com/intl/cms/s/0/00c12f6a-4b44-11e1-88a3-00144feabdc0.html#axzz1l1nEHAN1. [Accessed on: January 31, 2012]. Mackenzie, K. (2011). Who Has to Act on Treasuries? Available at: http://ftalphaville.ft.com/blog/2011/08/08/645711/who-has-to-act/. 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