Can Above Average Returns Be Earned On Observing Stock Market Overreaction?

9651 words - 39 pages

IntroductionThe efficient markets hypothesis (or EMH as it is known) and its predecessor, the random walk theory, are perhaps the most misunderstood concepts in the theory of investment. This is due partly to the back-to-front way in which the theory of efficient markets has evolved and partly to the misleading and emotive statements often ascribed to these theories, for example; 'Investment analysis is a total waste of time' and 'No one can beat the market'.The question of whether the stock market is efficient in pricing shares and other securities has fascinated academics, investors, and businessmen for a long time. This is hardly surprising: even academics are attracted by the thought that by studying in this area they might be able to discover a stock market inefficiency which is sufficiently exploitable to make them rich, or at least, to make their name in the academic community.Anyone investing on the stock market hopes to earn superior returns - to make a 'killing'. But making money from buying and selling securities on the capital markets is not, as many suppose, a matter of being able to predict the winners by studying the past. According to the EMH, such forecasts are nothing more than elaborate guess-work which, on average, are unlikely to be accurate. Ergo, in an efficient market undervalued or overvalued securities do not exist, and therefore it is not possible to develop trading rules which will 'beat the market'. However, if the market is inefficient it regularly prices securities incorrectly, allowing a perceptive investor to identify profitable trading opportunities. It is this that provides the fundamental reason for this paper.The central hypothesis to this piece of work has been inspired by the principal theme of the EMH that 'no one can beat the market'. The general consensus is that if no one can beat the market it is efficient, and conversely, inefficient if it is possible to beat the market. Over the decades numerous researchers have claimed to have developed a strategy which guarantees investors to beat the market. This subject is commonly presented with many influential articles; none more so than those based around stock market overreaction. However, conclusion is yet to be reached on whether or not it is possible toachieve above-average returns by manipulating stock market overreaction.Therefore, I propose to examine the behaviour of common stock prices after a large change in price occurs during a single trading day and present an argument that the stock market has overreacted, particularly in the case of 'price declines'. If it appears that the market has overreacted and that large changes in the prices of individual securities are followed by a reversal this could be interpreted as being at variance with the efficient market hypothesis. If this is the case, a specific trading rule could be applied in order to make short-term profit based on observing the previous days trading.Overall there has been extensive...

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