The implications of the theories of the stock markets on investers

Many investors use formula plans such as dollar-cost averaging to avoid having to time the markets. These plans eliminate the need for timing the markets, although investors still need to choose the stocks to buy and sell using these plans. By buying shares of stocks over a specified period at different prices, investors lessen the effect of price fluctuations. Bear in mind that if the markets plummet, these methods do not result in investors not losing money. These methods keep investors in the markets whether the market is going up or down.

You can find formula plans and investment strategies for buying and selling stocks, but no “magic” plan for beating the market exists. Some investment strategies have produced returns superior to those earned by the stock market as a whole over various periods. However, over long periods, consistently beating the market becomes exceedingly difficult.

Investors still need to decide which stocks to invest in and when to buy and sell. Fundamental analysis provides insight into the makeup of a company and its industry, which may be helpful in the selection of stocks for the long term. Technical analysis uses past price and volume information as well as charting to determine when to buy and sell stocks. The efficient market hypothesis renders technical analysis a waste of time because, according to the hypothesis, past stock prices reflect all available information. Therefore, the movements of past stock prices have no relationships to future prices. The relationship between past and future stock prices reflects the weak form of the efficient market hypothesis. The semistrong form suggests that no undervalued or overvalued stocks exist because all public information is reflected in the stock prices, which is a kick in the teeth to fundamental analysts. The strong form implies that the markets are perfect. They have digested all information pertaining to a stock’s value.

Little evidence exists to support the strong form. But some contradictions of the semistrong form suggest that the market has inefficiencies, particularly with regard to small stocks that have been ignored by fundamental analysts. After all, it is the fundamental analysts, in competition with one another, who make the markets more efficient, which lends support for the semistrong form.

The CAPM differentiates the risk in the portfolio into two parts: systematic and unsystematic risk. A diversified portfolio of stocks eliminates only unsystematic risk, which leaves the portfolio exposed to systematic risk. Thus, to earn higher returns in the market, you have to invest in stocks with higher beta factors (a coefficient measuring the systematic or market risk) than the market has. The theories of stock prices and the market are important for three reasons:
* Investors will not consistently earn superior returns over those of the stock market for long periods.
* Diversification of a portfolio can reduce the overall risk of the portfolio.
* The way to increase returns is to invest in riskier securities. However, if the market “heads south,” the riskier securities decline by more than the averages of the market. Other studies, such as the one by Fama and French (1992), show the opposite effect. The lowest-risk securities outperform the highest-risk securities.

These theories and reasons emphasize the importance of the construction of a portfolio of investments that is compatible with an investor’s overall risk comfort level. Diversification can accomplish this goal and eliminate some risk. Furthermore, investors can improve returns by holding securities for at least a year to qualify for the lower capital gains taxes and the reduction of investment fees and commissions.

Tax planning can reduce taxes and increase returns to some extent. Long-term capital gains (securities held for longer than one year that are sold at more than their original purchase price) are taxed at lower rates than the higher marginal tax rates for ordinary income and short-term gains (investments held for less than one year). Capital gains become much more important than ordinary income for high-tax-bracket investors. Dividends also receive favorable tax treatment. In the years 2003 through 2008, dividends will be taxed at lower rates than the marginal-tax-bracket rates.

Reducing or eliminating fees and sales commissions can increase returns significantly. Because many brokers make their money by buying and selling securities, they have an incentive to advise their clients to trade more than they should. This process, called churning, involves the buying and selling of stocks at a rate that is not justified by their returns.

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Failure to control Risk
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Lack of Discipline
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