Tutorial in Week 10 (based on Week 9 Lecture) beginning 7th May 2018

TOPIC: Market Efficiency

Q1 Prof Burton Malkiel in his book a Random Walk down Wallstreet argued that
randomly throwing darts at a list of shares traded on the New York Stock Exchange
would earn just as a high return as the returns earned by professional money managers.
Use efficient securities market theory to explain how “dart throwing” may be a
desirable investment strategy.

Under securities market efficiency, share prices at all times fully reflect all publicly available
information. Then, there is little point in trying to beat the market price. This requires costly
investment analysis with little hope of reward. Instead, a random selection of shares, for
example, by “dart-throwing,” will costlessly produce a portfolio with average risk (since the
average beta across all stocks is 1, we would expect the beta of a randomly chosen portfolio to
be 1) and a rate of return commensurate with this risk. If the investor desired more or less than
average risk, this can be accomplished by borrowing at the risk-free rate or buying a risk-free
asset.

Q2 Explain in your own words what “post-announcement drift” is. Why is this an
anomaly for security market efficiency? Give two behavioral biases that could generate
post-announcement drift? Provide a rational explanation for the drift.

Post-announcement drift is the tendency for the share prices of firms that report GN or BN in
quarterly earnings to drift upwards and downwards, respectively, for a lengthy period of time
following the release of the earnings report.
It is known that quarterly seasonal earnings changes are positively correlated. The reporting of,
say, GN this quarter (compared with the same quarter last year) increases the probability of
reporting GN next quarter as well. Thus, current quarterly earnings have two components of
information content. One component is their information content per se—they provide current
GN or BN that enables investors to revise their beliefs about future firm performance. Second,
they increase the probability of GN or BN in future quarters, which will enable a further belief
revision.

This is an anomaly for efficient securities markets theory because, to the extent that the drift is
not explained by barriers to arbitrage such as idiosyncratic risk or transactions costs, share
prices should respond immediately to all the information content of earnings, according to the
theory. However, this does not seem to happen. Instead, the market takes a lengthy period of
time to figure this out or, alternatively, it waits until the current implications are validated in
subsequent quarterly reports.
Post announcement drift may or may not imply non-rational investors. On the one hand, it
could be driven by behavioural biases such as conservatism or limited attention. On the other
hand, it could be driven by the uncertainty of rational investors about whether the firm’s
expected earning power has in fact increased (for GN) or decreased (for BN). In the face of
this uncertainty, investors attach some probability to each possibility, and revise their
probabilities over time as new evidence appears. These revisions will produce an upward or
downward drift in share price over time.

Q3 An investor considers two mutual funds. Based on past experience, the first fund has
an expected return of 0.08 and a standard deviation of 0.05. The second fund has an
expected return of 0.07 and a standard deviation of 0.06. There is no reason to assume
that future performance of these funds will differ from past performance. However, the
second fund has a guarantee attached that the return in any year will not be negative.
(a) Which fund would a rational investor buy (b) The investor buys the second fund.
Use prospect theory to explain why.

According to rational single-person decision theory, the investor will prefer the first fund,
since it has both a higher expected return and a lower risk.
According to prospect theory, however, investors will separately evaluate gains and losses on
their investment prospects, and the rate of decrease of utility for small losses may be
considerably greater than the rate of increase of utility from small gains. Since the second
fund truncates the fund losses, this gives it an advantage over the first fund.

Q4. Hossain and List (2009) conducted an experiment in a Chinese high-tech factory.
Some workers were told they would receive a bonus of 80 yuan if they meet a weekly
production target. Others were told that they had actually been awarded the as bonus,
but that they would lose it if they did not meet the target. Use prospect theory to
predict which compensation scheme would have the greatest effect on productivity.

In both cases, productivity improved, but the improvement was 1% greater in the second
case. It seems the fear of loss had a somewhat stronger effect on productivity than the
prospect of a gain. This is explained by prospect theory which shows that people will
separately evaluate prospective gains and losses and the disutility of even very small losses is
greater than the utility from small gains.

Q5 Use concepts from behavioural finance to explain why the market may overreact to
changes in “earnings” expectation.

Behavioural concepts leading to market overreaction to earnings expectations include self-

attribution bias, representativeness, and overconfidence. Self-attribution bias causes investors’
faith in their investment ability to rise following GN in earnings, leading to the purchase of
more shares and development of share price momentum. Momentum is reinforced by positive
feedback investors, who buy when share price starts to rise, and vice versa.

Investors subject to representativeness assign too much weight to current evidence, such as
earnings growth. Then, the market will overreact to GN in earnings.

Overconfident investors overestimate the precision of information they collect themselves,

such as financial statement information. Then, if the firm reports, say, BN they revise their
probability of poor future firm performance by more than they should according to Bayes’
theorem. This leads to share price overreaction to the BN.

Market overreaction to (negative) changes in earnings expectations is also predicted by

prospect theory. Under this theory, a reduction in prospects for future earnings lowers investor
utility by more than it is increased by a corresponding increase in prospects. Then, we would
expect a relatively strong market reaction if earnings forecasts are not met. However, prospect
theory also predicts that investors will tend to hold on to ”loser” stocks. This would tend to
reduce, rather than increase, market reaction to a reduction in earnings expectations. Thus, the
extent to which investors’ probability weightings contribute to market overreaction under
prospect theory is not clear.