Chapter 12

Market Efficiency and Behavioral Finance

Chapter 12

Efficient Market Hypothesis (EMH)

Are security markets efficient relative to the
information available for valuing securities?
Do security prices reflect relevant information
quickly and accurately?
Why look at market efficiency?
Implications for business and corporate finance
Implications for investment

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Random Walk and the EMH

Random Walk - stock price changes are
random
Actually submartingale
Expected price is positive over time
Positive trend and random about the trend

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Random Walk with Positive Trend

Security
Prices

Time
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Market Efficiency
The Efficient Market Hypothesis (EMH) is a
hypothesis that asserts: As a practical matter, the major
financial markets reflect all relevant information at a
given time.
Market efficiency research examines the relationship
between stock prices and available information.
The important research question: Is it possible for investors to
beat the market?
Prediction of the EMH theory: If a market is efficient, it is not
possible to beat the market (except by luck).

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What Does Beat the Market Mean?

The excess return on an investment is the return
in excess of that earned by other investments that
have the same risk.
Beating the market means consistently earning
a positive excess return.

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Forms of Market Efficiency,

(i.e., What Information is Used?)
A Weak-form Efficient Market is one in which past prices and
volume figures are of no use in beating the market.
If so, then technical analysis is of little use.

A Semistrong-form Efficient Market is one in which publicly

available information is of no use in beating the market.
If so, then fundamental analysis is of little use.

A Strong-form Efficient Market is one in which information of any

kind, public or private, is of no use in beating the market.
If so, then inside information is of little use.
Securities law regulates insider trading, so the law believe
markets are not strong form efficient.

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Why Would a Market be Efficient?

The driving force toward market efficiency is simply

competition and the profit motive.
Even a relatively small performance enhancement can
be worth a tremendous amount of money (when
multiplied by the dollar amount involved).
This creates incentives to unearth relevant information
and use it.

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Random Price Changes

Why are price changes random?
Prices react to information
Flow of information is random
Therefore, price changes are random

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EMH and Competition

Stock prices fully and accurately reflect
publicly available information.
Once information becomes available,
market participants analyze it.
Competition assures prices reflect
information.

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Types of Stock Analysis

Technical Analysis - using prices and
volume information to predict future
prices.
If securities markets are weak form efficient,
then technical analysis is useless

Fundamental Analysis - using economic

and accounting information to predict
stock prices.
If securities markets are semi strong form
efficient, then fundamental analysis is
useless
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Technical Analysis
Technical analysis differs significantly from
fundamental analysis.
Technical analysis is a controversial set of techniques
for predicting market direction based on
Historical price and volume behavior
Investor sentiment

Technical analysts essentially search for bullish

(positive) and bearish (negative) signals about stock
prices or market direction.

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Dow Theory, I.
The Dow theory is a method that attempts to interpret
and signal changes in the stock market direction.
Historically, quite popular.
The Dow theory identifies three forces:
a primary direction or trend,
a secondary reaction or trend, and
daily fluctuations

Daily fluctuations are essentially noise and are of no real

importance.
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Dow Theory, II.

The primary direction is either bullish or bearish,

and reflects the long-run direction of the market.

Secondary
trends,
temporary
departures

Corrections,
reversions to the
primary direction

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Dow Theory, III.

Purpose: to signal changes in the primary direction.
Must monitor two indexes:
Dow Jones Industrial Average
Dow Jones Transportation Average

If ONE index departs from the primary direction, this is

not a signal.
However, if a departure in one is followed by a departure
in the other, this is viewed is confirmation that the trend
has changed.
The trend is your friend
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Support and Resistance Levels

A support level is a price or level below which a stock or
the market as a whole is unlikely to go, while a
Resistance level is a price or level above which a stock
or the market as a whole is unlikely to rise.
Resistance and support areas are usually viewed as
psychological barriers
Bargain hunters help support the lower level.
Profit takers resist the upper level.

A breakout occurs when a stock (or the market) passes

through either a support or a resistance level.
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Market Diaries,
A Collection of Technical Indicators

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Technical Indicators, Notes

The advance/decline line shows, for some period, the cumulative
difference between advancing and declining issues.
Closing tick is the difference between the number of shares that
closed on an uptick and those that closed on a downtick.
Closing arms or trin (trading index) is the ratio of average
trading volume in declining issues to average trading volume in
advancing issues. Using data from the "Previous Close:"
Arms

754,540,57 0/1,734 435,144

1.6944
384,700,63 0/1,498 256,809

zBlock trades are trades in excess of 10,000 shares.

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Charting, Relative Strength

Relative strength charts measure the performance of
one investment relative to another.
Comparing stock A to stock B, through relative strength.
Stock A
(4 Shares)

Stock B
(2 Shares)

Relative
Strength

$100

$100

1.00

96

96

1.00

88

90

0.98

88

80

1.10

80

78

1.03

76

76

1.00

Month

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Charting, Moving Averages

Moving average charts are average daily prices or index
levels, calculated using a fixed number of previous days
prices or levels, updated each day.
Because daily price fluctuations are smoothed out,
these charts are used to identify trends.
Example: Suppose the technical trader calculates a 15day and a 50-day moving average of a stock price.
If the 15-day crosses the 50-day from above, it is a bearish
signaltime to sell.
If the 15-day crosses the 50-day from below, it is a bullish signal
time to buy.
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Example: 15-Day and

50-Day Moving Averages

Note the "whipsaw" actioni.e., plenty of buying and selling signals.

This happens because 15 and 50 may be too "close" together in time.
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More Chart Types

A hi-lo-close chart is a bar chart showing, for each day,
the high price, low price, and closing price.
A candlestick chart is an extended version of the hi-loclose chart. It plots the high, low, open, and closing
prices, and also shows whether the closing price was
above or below the opening price.

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Candlestick Making, Basics

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Candlestick Formations

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Point and Figure Charts, I.

Point-and-figure charts attempt to show only major price
moves and their direction.
The point and figure chart maker decides what price move is major.
That is, it could be $2, $5, or any other level.

A major up-move is marked with an X

A major down-move is marked with an O
Start a new column when there is a direction change.
Buy and sell signals are generated when new highs or new lows are
reached.
Congestion area, the area between buy and sell signalsa time of
market indecision concerning its trend.
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Point and Figure Charts, II.

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Point and Figure Charts, III.

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Chart Formations
Once a chart is drawn, technical analysts examine it for
various formations or pattern types in an attempt to
predict stock price or market direction.
One example is the head-and-shoulders formation.
When the stock price pierces the neckline after the right
shoulder is finished, it is time to sell.

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Chart Formations, The Head and Shoulders

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Other Technical Indicators

The odd-lot indicator looks at whether odd-lot
purchases are up or down.
Followers of the hemline indicator claim that hemlines
tend to rise in good times.
The Super Bowl indicator forecasts the direction of the
market based on who wins the game.
Two Conference representatives play in the Super Bowl: one
from the National Football Conference and one from the
American Football Conference.
A win by the National Football Conference (or one of the original
members of the National Football League) is bullish.
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Are Financial Markets Efficient?

Nevertheless, three generalities about market
efficiency can be made:
Short-term stock price and market movements appear
to be difficult to predict with any accuracy.
The market reacts quickly and sharply to new
information, and various studies find little or no evidence
that such reactions can be profitably exploited.
If the stock market can be beaten, the way to do so is
not obvious.
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Some Implications if Markets are Efficient

Security selection becomes less important,
because securities will be fairly priced.
There will be a small role for professional
money managers.
It makes little sense to time the market.

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Active or Passive Management

Active Management
Security analysis
Timing

Passive Management
Buy and Hold
Index Funds

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Market Efficiency & Portfolio Management

Even if the market is efficient a role exists
for portfolio management:
Diversification still matters
Tax considerations
Appropriate risk level
Other considerations
Age
Personal knowledge
Personal circumstances
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Empirical Tests of Market Efficiency

Event studies
Assessing performance of professional
managers
Testing some trading rule

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Event Studies: How Tests Are Structured

1.

Examine prices and returns over time

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Returns Over Time

-t

+t

Announcement Date
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How Tests Are Structured (contd)

2. Returns are adjusted to determine if they

are abnormal.
Market Model approach
a. Rt = at + btRMt + et
(Expected Return)
b. Excess Return =
(Actual - Expected)
et = Actual - (at + btRMt)

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How Tests Are Structured (contd)

2. Returns are adjusted to determine if they are

abnormal.
Market Model approach
c. Cumulate the excess returns over time:
See Figure 12.1

-t

+t
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Issues in Examining the Results

Magnitude Issue
Someone researching for a large fund only
needs a small gain to justify the research
too small too measure, relative to noise

Selection Bias Issue

Those who know how to beat the market
keep it a secret (or else everyone would do it;
thus, we dont know how to study those who
beat the market

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Issues in Examining the Results

Lucky Event Issue
Was it luck or skill? Even in a Candy Land
tournament, there will be a winner (and a
loser)

Possible Model Misspecification

Are we making the correct risk adjustment
when we make our comparisons. What if
beta is not the correct way to measure risk?
What if risk changes over time?

Data snooping all random data will have

parts that look non random
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What Does the Evidence Show?

Technical Analysis
Short horizon: Very short time horizons (weekly)
shows some reversals, but not enough to trade
profitably on (Negative serial correlations). Longer
horizons (3 month to a year) shows that momentum
exits, not in individual stocks, but in portfolios, with
enough gain to cover trading costs (positive serial
correlations).
Long horizon: Fama and French find a long term
negative serial correlation in the aggregate market.
DeBont and Thaler find contrarian investing (winner
and loser portfolios) over 5 years leads to excess
return (January to January). Other researchers
found much of the effect disappears if one looks at
July to July.
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What Does the Evidence Show?

Fundamental Analysis
Broad market returns seem to be influenced
by dividend yields, earnings yields, bond yield
spreads. These may simply be proxies for
changing betas.
Many event studies reinforce semi strong
market efficiency such as Figure 12.1

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What Does the Evidence Show?

Anomalies Exist
Anomalies are empirical results that are
known, but should not exist in an efficient
market. Is that beta is an incomplete or even
wrong measure of risk, or are markets not
efficient?
For example, Basu found a P/E effect, after
adjusting for Beta. Is there a P/E effect, or is
P/E just a measure of the firm risk, that adjust
quickly, while a beta measurement is based
on long term data?
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Stock Price Behavior and Market Efficiency

The day-of-the-week effect refers to the tendency for
Monday to have a negative average return.

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The Amazing January Effect, I.

The January effect refers to the tendency for small
stocks to have large returns in January.
Does it exist for the S&P 500?

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The Amazing January Effect, II.

The January effect refers to the tendency for small
stocks to have large returns in January. What do we
see when we look at returns on small stocks?

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The Market Crash in October 1987

On October 19, 1987 (Black Monday), the Dow
plummeted 500 points to 1,700.
Investors lost about $500 billion in share value.
The market lost over 20% of its value.
The volume was a record at the time: 600 million
shares.

Today the NYSE has circuit breakers.

Rules that kick in to slow or stop trading when the
DJIA decreases (or increases) by more than a preset amount in a trading session.
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The Performance of
Professional Money Managers
From 1963 to 1998, the S&P 500 index outperformed
general equity mutual funds 22 times (out of 36).
Why cant the pros beat the averages? (You can hold a
market average very easilySPDRs)

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Other Anomalies
Neglected Firm
Neglected firms are typically small firms for which
there is little analyst coverage. Tend to have higher
returns may be due to lack of liquidity. Suggests
this a risk premium in addition to beta

Market to Book Ratios

market to book ratios seem to explain returns better
than beta

Post-Earnings Announcement Drift

( see Figure 12.7). The reaction to earnings
announcement continues after the announcement
date.
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Strong Form Efficiency Tests

Tests of insider trading suggests that insiders
can usually beat the market suggest that
markets are relatively efficient, up to semi
strong form. Trying to mimic insiders does not
seem to be of value, after their trades are
reported.

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Explanations of Anomalies
May be risk premiums (but not beta)
Behavioral Explanations
What if people dont act rationally? Does that
mean prices are irrational? Some irrational
decisions will create profit opportunities for
arbitrageurs, so there will be limits to the
degree of irrationality.

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Information Processing
Forecasting Errors people put too much
weight on recent evidence (one good exam
grade does not necessarily mean you will ace
the course or one good quarter does not means
the firms prospects are forever better)
Overconfidence people tend to be over
confident in their beliefs. Those who trade a lot
(confident in their beliefs) do worse than others.
Conservatism some people under react
Sample Size Neglect and Representativeness
anecdotal evidence move people more than
large statistical samples
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Behavioral Biases
Framing On the risk tolerance quiz, the
same question mathematically, often
reversed the answer, when asked a
different way
Mental Accounting we budget in our
mind for certain things. People are more
likely to make risky gambles with the
house money than with their own.
Regret Avoidance certain losses cause
more pain than others, even if the dollar
amount is the same.
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Limits to Arbitrage
Fundamental Risk if prices wander too long,
those trying to gain, may in the short term lose
(E.g. Priceline short seller)
Implementation Costs - transactions costs may
limit arbitrage.
Model Risk what if your arbitrage model is
wrong?
Result: Prices could be wrong (do not reflect
fundamentals) but its hard to profit from the
apparent opportunities. In other words,
absence of profit potential does not imply EMH
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Mutual Fund Performance

Some evidence of persistent positive and
negative performance.
Potential measurement error for
benchmark returns.
Style changes: When Elton et. Al. compared
results to 3 potential index funds (large
stocks, small stocks, bonds), mutual funds
showed negative (but mostly not significant)
alphas.
May be risk premiums
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So, are markets efficient?

Theres the story of the finance professor
walking with a graduate student who spies a
$20 bill on the sidewalk. The professor says
there is no point picking up the $20 bill as if
there really was a $20 bill on the sidewalk
someone else would have picked it up already

Superstar phenomenon:
Who are the best investors of all time? Peter Lynch,
Warren Buffet, John Templeton, Jeff Neff. Why are
there so few in the club?

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