What are the positive aspects of this theory -explain how markets behave? Why?
The positive aspects of this theory are that it identifies changes in the markets early. This helps investors to be able to purchase stocks when everyone has become overly pessimistic (leading to a massive selloff). At the same time, this theory helps to determine when the underlying trends could be changing (with investors becoming overly optimistic). This helps these individuals to reduce their risks and increase the chances of realizing above average returns. (Livingston 2012)
A good example of this occurred in 2008 when the federal government was providing assistance to large financial institutions such as: AIG and Citigroup. At the time, the markets were in a free fall surrounding fears that the issues with housing market will cause a major economic implosion. Moreover, investors were fearful about the possibility of the Big Three Automakers entering bankruptcy (which could make the underlying situation even worse). When this was happening, many contrarian investors were seeking out good long-term buys that can be purchased for a fraction of their value. (for Berkshire Hathaway's Warren Buffett 2009)
In the case of Warren Buffett, he was aggressively purchasing shares of Wells Fargo throughout the entire financial crisis. After one purchase in 2009, he said that he really liked the good investment opportunities inside the United States by commenting, "I've been buying American stocks. This is my personal account I'm talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) if prices keep looking attractive, my non-Berkshire net worth will soon be 100% in United States equities." The impact of making these kinds of purchases helped to increase the value of his portfolio by 259.36%. This is higher than the performance of the Dow Jones Industrial Average (which is up 85.87% since this time). These figures are showing how the EMH produces worse than expected results in comparison with various forms of contrarian investing. The fact that Warren Buffett and other successful investors have been able to use this strategy consistently is an indication of how it can produce superior results in comparison with the EMH. (Wells Fargo 2012) (Dow Jones Industrial Average 2012) (for Berkshire Hathaway's Warren Buffett 2009)
What are the negative aspects of this theory -explain how markets behave? Why?
The negative aspects of this theory are that the markets could overshoot when there is a clear buy or sell signal. This can cause investors to lose money with the current trend continuing despite the classic buy or sell signs. This is because the approach is focused on identifying shifts early. As a result, this is indicating the final stage of a trend (which will increase the volatility and momentum). (Livingston 2012)
Clearly, the EMH is a flawed theory. The biggest reason is from the strategy ignoring the price of the stock, the economic background, the financials and other factors. This increases the chance that investors will see below average returns with higher amounts of risk. In many cases, this means that investors could be purchasing stocks that are beginning to see adverse changes to their earnings. When this happens, the odds increase that the company will face tremendous amounts of selling pressure. In the case of behavioral finance, these areas are looking at how the price is performing in relation to the markets. When the averages are going through periods of extreme challenges is the point that these ideas can increase the overall returns in the portfolio. As a result, this is why some of the most successful investors are using these tools on a regular basis.
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