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(b)
Ans.2 The thought of markets being efficient is a paradox in
itself. If everyone believed in efficient markets then nobody would
bother looking for anomalies, so if anomalies existed they
wouldn’t be found and the market would be inefficient without
anybody realizing. However, if people believe the markets are
inefficient then they look for anomalies and take advantage of
them, and in turn eliminate the opportunities that they bring. This
contributes to making the markets more efficient.
Why doesn’t then everyone use the Markowitz model to solve their
investment problems? The answer lies in the statistics that are
required as inputs for the model. The historical mean return of
securities may be a poor estimate of their future mean return. As
we increase the number of securities, we increase the number of
correlations that we must estimate-and they must be estimated
correctly to obtain the right answer.
In fact, with more than thousands of stocks listed on the BSE and
NSE, it is almost certain that we will find correlations that are
widely inaccurate for the purpose of estimating future correlations.
Unfortunately, the markowitz model does not deal well with
incorrect inputs. That is why the model is best applied to allocation
decisions across asset classes are well-estimated.