Module 5: Market Movement & Risk

There are three forms of the Efficient Market Hypothesis that is used to explain market movements: weak, semi-strong, and strong.

The weak form of EMH says that stock prices reflect historic price changes and volumes. This means that it is possible to "beat the market" and use historic data to identify patterns.

The semi-strong form says that stock prices already reflect all publicly available information, which means it is very hard to consistently beat the market.

In the same vein, the strong form says that stock prices reflect all information, public and private, including insider information.

Most analysts and professionals agree that, in reality, the market represents a middleground between the semi-strong and strong forms of EMH. In essence, this means that prices move when new information comes out that investors did not expect. This is why surprises in earnings reports or economic data have such a big impact. When a company performs better or worse than analysts expected, the stock price quickly adjusts accordingly to reflect the new information.

In general, there are two types of risk that affect every security in the market: systematic and idiosyncratic risks.

Systematic or Market risk is the kind of risk that affects the whole market, such as interest rate changes or recessions. You cannot avoid this type of risk no matter how many different stocks you own.

Idiosyncratic or Unsystematic risk is specific to a single company or industry, like a product recall or management failure. This type of risk can be reduced through diversification.

To measure these risks, two measures are commonly used: Standard Deviation and Beta.

As discussed in the previous module, standard deviation measures how much an investment's returns tend to move up or down from their average, capturing both systematic and idiosyncratic risks. A higher standard deviation means the investment is more volatile and less predictable.

On the other hand, beta looks at how much an investment moves relative to the overall market. In measuring the covariance between the security's returns and the overall market, beta gives investors an idea of the amount of systematic risk associated with the security. A beta above one means it tends to move more than the market, while a beta below one means it is relatively more stable.