Achieving Consistent Profits Through Effective Risk Management – The efficient market hypothesis (EMH), alternatively known as efficient market theory, is a hypothesis that states that stock prices reflect all information and consistent alpha generation is not possible.

According to the EMH, stocks on stock exchanges always trade at their fair value, which makes it impossible for investors to buy undervalued stocks or sell stocks at inflated prices. Therefore, it should not be possible to beat the overall market through expert stock selection or market timing, and the only way an investor can achieve higher returns is by buying riskier investments.

Achieving Consistent Profits Through Effective Risk Management

Achieving Consistent Profits Through Effective Risk Management

Although the EMH is a cornerstone of modern financial theory, it is highly controversial and often disputed. Believers say there is no point in looking for undervalued stocks or trying to predict market trends through fundamental or technical analysis.

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In theory, neither technical nor fundamental analysis can consistently produce excess risk-adjusted returns (alpha), and only inside information can lead to excess risk-adjusted returns.

Stock price of the world’s most expensive stock as of June 27, 2022: Berkshire Hathaway Inc. Class A (BRK.A).

While academics point to a large body of evidence in support of the EMH, there is an equal amount of disagreement. For example, investors like Warren Buffett have consistently beaten the market over long periods of time, which is impossible by definition according to the EMH.

Critics of the EMH also point to events such as the stock market crash of 1987, when the Dow Jones Industrial Average (DJIA) fell more than 20% in a single day, and asset bubbles as evidence that stock prices can deviate seriously from their true values . .

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The assumption that markets are efficient is a cornerstone of modern financial economics, which is being questioned in practice.

Proponents of the efficient market hypothesis conclude that due to market randomness, investors could do better by investing in a low-cost passive portfolio.

Data collected by Morningstar Inc. in their June 2019 Active/Passive Barometer study they support the EMH. Morningstar compared the returns of active managers across all categories to a composite of related index and exchange-traded funds (ETFs). The study found that over a 10-year period from June 2009, only 23% of active managers were able to outperform their passive counterparts. Better success was recorded by foreign equity funds and bond funds. Lower success rates were found in US large-cap funds. In general, investors have done better by investing in low-cost index funds, or ETFs.

Achieving Consistent Profits Through Effective Risk Management

While a percentage of active managers will outperform passive funds at some point, the challenge for investors is to see which ones will do so over the long term. Fewer than 25 percent of top performing active managers can consistently outperform their passive managers over time.

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Market efficiency refers to how well prices reflect all available information. The Efficient Markets Hypothesis (EMH) states that markets are efficient and leave no room for making excessive profits by investing because everything is already fairly and accurately priced. This means there is little hope of beating the market, although you can match market returns by passively investing in the index.

The validity of the EMH has been questioned on both theoretical and empirical grounds. There are investors who beat the market, such as Warren Buffett, whose investment strategy focused on undervalued stocks made him billions and set an example for many followers. There are portfolio managers who perform better than others, and there are investment houses with more reputable research analysis than others. However, proponents of the EMH argue that those who outperform the market do so not because of skill, but because of luck due to the laws of probability: at any given time in a market with a large number of players, some will outperform the average, while others will underperform.

There are certainly markets that are less efficient than others. An inefficient market is one in which the prices of an asset do not accurately reflect its true value, which can occur for a number of reasons. Market inefficiencies can exist due to information asymmetry, lack of buyers and sellers (i.e., low liquidity), high transaction costs or delays, market psychology, and human emotions, among others. Inefficiency often leads to dead weight. In fact, most markets exhibit some level of inefficiency, and in the extreme case, an inefficient market can be an example of market failure.

Accepting the EMH in its purest (strong) form can be difficult because it states that all information in the market, whether public or private, is included in the price of the stock. However, there are modifications to the EMH that reflect the extent to which it can be applied to markets:

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The more participants in the market, the more efficient it will be, as more people will compete and bring more different types of information that affect the price. As markets become more active and liquid, arbitrage advisors will also emerge to benefit from correcting small inefficiencies whenever they may occur and quickly restoring efficiency.

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The offers that appear in this table are from the partnerships from which they receive compensation. This compensation may affect how and where listings are displayed. does not include all offers available on the market. Risk management involves identifying, analyzing and accepting or mitigating uncertainty in investment decisions. Simply put, it is the process of monitoring and dealing with financial risks associated with investing. Essentially, risk management occurs when an investor or fund manager analyzes and attempts to quantify the potential for loss in an investment, such as moral hazard, and then takes appropriate action (or inaction) to meet their objectives and risk tolerance.

Achieving Consistent Profits Through Effective Risk Management

Risk is inseparable from return. Every investment involves a certain degree of risk. It can be close to zero for US Treasury bills or very high for emerging market stocks or real estate in highly inflationary markets. Risk is quantified in absolute and relative terms. A thorough understanding of risk in its various forms can help investors better understand the opportunities, trade-offs and costs associated with different investment approaches.

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Risk management involves identifying and analyzing where risk exists and making decisions about how to deal with it. It occurs everywhere in finance. For example:

Consistent risk management can help reduce the likelihood of losses while ensuring financial goals are met. However, insufficient risk management can have serious consequences for companies, individuals and the economy. The subprime meltdown that led to the Great Recession stemmed from poor risk management. Lenders gave mortgages to people with bad credit, and investment firms bought, packaged, and resold those loans to investors as risky mortgage-backed securities (MBS).

The word risk is often perceived negatively. However, risk is an integral part of the investment world and is inseparable from performance.

Investment risk is a deviation from the expected result. This deviation is expressed in absolute numbers or relative to something other than a market benchmark. Investment professionals generally accept the idea that variance implies some degree of intended outcome for your investments, whether positive or negative.

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You are expected to take more risk to achieve higher returns. It is also a generally accepted idea that increased risk means increased volatility. While investment professionals are constantly looking for and occasionally finding ways to reduce volatility, there is no clear agreement on how to do this.

How much volatility an investor should accept depends entirely on their risk tolerance. For investment professionals, this is based on the tolerance of their investment goals. One of the most commonly used absolute risk metrics is the standard deviation, which is a statistical measure of the dispersion around the central tendency.

Here’s how it works. Take the average return on an investment and find its average standard deviation over the same time period. Normal distributions (the familiar bell curve) dictate that the expected return on an investment can be one standard deviation from the mean 67% of the time and two standard deviations from the mean 95% of the time. This provides a numerical risk assessment. If the risk is tolerable (financially and emotionally), they can invest.

Achieving Consistent Profits Through Effective Risk Management

Behavioral finance highlights the imbalance between people’s views on profits and losses. In prospect theory, an area of ​​behavioral finance introduced by Amos Tversky and Daniel Kahneman in 1979, investors exhibit loss aversion.

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They noted that investors give roughly twice as much weight to the pain associated with a loss as to the good feeling associated with a gain.

Investors often want to know the losses that come with an investment, as well as how much the asset deviates from the expected outcome. Value at Risk (VAR) seeks to quantify the degree of loss associated with an investment with a given level of confidence over a defined period. For example, an investor can lose $200 on a $1,000 investment with a 95% confidence level over a two-year time horizon. Keep in mind that a measure like VAR doesn’t guarantee that 5% of the time will be much

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