In this chapter we explore the reasoning behind what may seem a surprising conclusion. We show how competition among analysts leads naturally to market efficiency, and we examine the implications of the efficient market hypothesis for investment policy. We also consider empirical evidence that supports and contradicts the notion of market efficiency. | Chapter 12 Market Efficiency and Behavioral Finance Do security prices reflect information ? Why look at market efficiency? Implications for business and corporate finance Implications for investment Efficient Market Hypothesis (EMH) Random Walk - stock prices are random Actually submartingale Expected price is positive over time Positive trend and random about the trend Random Walk and the EMH Random Walk with Positive Trend Security Prices Time Why are price changes random? Prices react to information Flow of information is random Therefore, price changes are random Random Price Changes Stock prices fully and accurately reflect publicly available information. Once information becomes available, market participants analyze it. Competition assures prices reflect information. EMH and Competition Weak Semi-strong Strong Forms of the EMH Technical Analysis - using prices and volume information to predict future prices. Weak form efficiency & technical analysis Fundamental Analysis - using economic and accounting information to predict stock prices. Semi strong form efficiency & fundamental analysis Types of Stock Analysis Active Management Security analysis Timing Passive Management Buy and Hold Index Funds Active or Passive Management Even if the market is efficient a role exists for portfolio management: Appropriate risk level Tax considerations Other considerations Market Efficiency & Portfolio Management Event studies Assessing performance of professional managers Testing some trading rule Empirical Tests of Market Efficiency 1. Examine prices and returns over time How Tests Are Structured Returns Over Time 0 +t -t Announcement Date 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) How Tests Are Structured (cont’d) 2. Returns are adjusted to determine if they are abnormal. Market Model approach c. Cumulate the excess returns over time: 0 +t -t How Tests Are Structured (cont’d) Magnitude Issue Selection Bias Issue Lucky Event Issue Possible Model Misspecification Issues in Examining the Results Technical Analysis Short horizon Long horizon Fundamental Analysis Anomalies Exist What Does the Evidence Show? Small Firm Effect (January Effect) Neglected Firm Market to Book Ratios Reversals Post-Earnings Announcement Drift Anomalies Explanations of Anomalies May be risk premiums Behavioral Explanations Information Processing Errors Behavioral Biases Limits to Arbitrage Information Processing Forecasting Errors Overconfidence Conservatism Sample Neglect and Representativeness Behavioral Biases Framing Mental Accounting Regret Avoidance Limits to Arbitrage Fundamental Risk Implementation Costs Model Risk Some evidence of persistent positive and negative performance. Potential measurement error for benchmark returns. Style changes May be risk premiums Superstar phenomenon Mutual Fund Performance
