Investing Feeds

In all of the theory which I have covered in my articles I have often referred to a perfect market, or perfect conditions. It is important that potential investors understand what is meant by Perfect Market in relation to theory. A perfect market has two sides, first the companies or entities involved in the market would behave in a mathematically perfect way in terms of investment and financing, they would all utilize NPV analysis to make decisions and would subscribe to Fishers normative function of maximizing shareholder wealth. Secondly Investors would act in a perfect way by also utilizing NPV to make decisions about investing and financing decisions.

To a large extent this is what happens on the real world, but the perfect market also has other conditions which affect the use of NPV by entities in the market. The market would operate under conditions of certainty, future cash flows could be arrived exactly and risk would not exist. Further the market would be impervious to speculation (the trading of futures) and psychological impacts, such as the lack of confidence in the market directly after 9/11 for example.

Of course the market is not perfect, and so why do analysts use these perfect models to try to determine future events? The role of assumptions is important in building a picture of the unknown. We do not understand how the market operates in reality, but we also know, mathematically, how it should behave if we make certain assumptions about its perfection, therefore, when we observe the market doing something unexpected, we know it is because one of the assumptions about the perfect market is wrong. The fun part then is to try and figure out which part that is. For an exposition of this article, my next on the Gordon Growth Theory and the work of Modigliani and Miller is a case in point.

The market may not be perfect but we can demonstrate that it is reasonably efficient, as we can see that when bad news about a company’s operations hits the public domain, the share price falls and vice versa. Thus the real market is known to be in a state of efficiency, and not perfect.