Behavior minds of people. This theory is

Behavior Finance encompasses that behavioralbiases are a significant part of the investing community. People react todifferent news differently and show behavior which might not be logical at all.The progress of a stock is hugely dependent on the sentiment of the investorand the progress of which may be changes with no change in fundamental analysisof the stock.

The reason for such reaction can be attributed to the fact thatpeople sometimes overreact or underreact to information which may not belogical in any sense. Such people can be divided into two classes: Conservatisms,who are slow to change their beliefs in the face of new evidence and representativeheuristic who rely on previous or similar experiences to come to a decision.For example, the notion of good or bad company in the minds of people sets usbiases initially in the minds of people. This theory is hugely prevalentespecially for blue chip companies which garner a lot of goodwill hence ithelps them over price their securities Barberis, Shleifer & Vishny,1998).Another school of thought is the conceptof rational managers where company time their securities in periods of lowmarket returns to take advantage of positive investor sentiment and marketmismatch. The behavioral train of thought for stock selection is a prevalenttheory today with people starting from individual investor to hedge funds makeextensive use of it.

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. Advances in neuroscience has also made coordinatedestimation of musings and sentiments conceivable and offer the possibility tocomprehend why people settle on these choices.Efficient Market HypothesisThe efficient market hypothesis suggeststhat the stock prices fully incorporate all the information available in themarket and it reflects in the way investors start investing in the securities.

It says that there is no way by which you can make profits based on oldinformation as markets are efficient, they quickly adjust to information.Whenever new information comes to market, investor uses a variety of techniquesto identify under valued and over valued securities and invests accordingly tillthe price of the security stabilizes by so called market forces.There are 3 forms of efficient markets:·        The weak form of efficientmarket: It suggests that the current prices has incorporated all theinformation occurred in the past history only.·        The semi-strongform of efficient market: The current market prices fully incorporates allpublic information about the security and the market.·        Strong form of efficientmarket: It incorporates both public and private investments.Understudies of markets show thatbusinesses are hugely effective and one cannot simply make profits by analyzinghistorical prices of securities. Eventually, the effective markets speculationkeeps on being the best depiction of value developments in securities markets.

Modern Portfolio Theory:Markowitz’smodern portfolio theory based on efficient markets suggests that any time of uunsystematic risk can be eliminated by correctly making a portfolio of diversifiedstocks. It basically states that we can protect our portfolio against shocks inthe market by keeping in our portfolio stocks which are unrelated or notcorrelated. This basically means that since the stocks are unrelated ornegatively correlated so whenever any market shock stresses an existing stock,its unrelated partner stock will try to stabilize the portfolio by oppositeprice movements of the stock in question. A mixture or diversified portfolio ofstocks will always decrease the risk. Lack of correlation thus ensures that theassets follow different risk patterns against un predicted market behavior thussafeguarding our investment.Some of theterms associated with the hypothesis are: Efficient Frontier, which is agraphical representation of all possible weights of assets in a portfolioshowing the risk vs return with standard deviation being the proxy for risk.Tangency Portfolio is the point on efficient frontier where the risky assetsmeets the combination of risky and risk free assets(Capital Allocation Line).

Portfolio along the lower part of the hyperbole willhave lower return and eventually higher risk. Portfolios to the right will havehigher returns but also higher risk. This hypothesis was ground breaking workand today we can visibly see investors all around the globe follow thisprinciples to protect their investments from shocks.

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