Efficient market hypothesis
(Application of rational expectations in the pricing of securities)
a. stock price follow a random walk
P = P + n
t+1 t t+1
Where n ts random has a mean of zero; H is uncorrelated over time and has constant variance.
b.ex post returns (realized returns deviate from average market returns randomly)
Ke t K +eς t+1
The expectation of ς is zero. It is uncorrelated over time and has constant variance. Implication for
3.2 Implications for Investing (important part)
1) Published reports of financial analysts are not very valuable.
2) Should be skeptical of not tips, either the tips are old news (already reflected in the market price of
stocks) or privileged information subject to “insider-trading” penalties.
3) Stock prices may fall on good news. Hence the phrase “buy on rumour and sell on news”
3.3 Prescription for Investor
1) Should not try to outguess the market.
2) Therefore, buy and hold.
3) Diversify with no-load mutual fund or even better buy shares in a stock market index (i shares, exchange
i shares and ETFs are securities that tra