Explain the theoretical concepts that form the basis of the random walk hypothesis, and consider the implications of the efficient market hypothesis and the behavioural finance hypothesis when analysing and forecasting share price movements.

The random walk hypothesis contends that share price observations are independent of each other and that the next price movement cannot be directionally predicted.

That is, the next price of a share may be an increase or a decrease or it may remain the same. A change in a share price will occur in response to new information coming to the market.

The efficient market hypothesis is a formalisation of the information process of the random walk hypothesis

It challenges the view that analysts are able to select a portfolio of shares that will outperform the overall market. The challenge rests on the view that markets are information-efficient and therefore all relevant information is already reflected in the current price of a share.

Three forms of market efficiency are identified: 1 weak form efficiencywhere successive changes in the price of shares are independent of one another; therefore, investors cannot make superior profits on the basis of historic price data 2 semi-strong form efficiencywhere all publicly available information regarding a company is fully reflected in the price of a share 3 strong form efficiencywhere all information, including that which is publicly available and that which is available only through private inquiries and research, will be reflected fully in the market price of a share.

The majority of empirical studies find in favour of the first two forms of efficiency; however, there is less agreement on the strong form efficiency. Information efficiency may not be constant across all stocks listed on a stock exchange.

The behavioural finance hypothesis challenges aspects of the efficient market hypothesis and contends that psychological and cognitive factors actually influence the investment decision process.

Question:

15 A key finding in behavioural finance is that investors tend to keep their losing investments too long and sell their winning investments too soon. Use prospect theory (or other elements of behavioural finance) to explain this behaviour.