Are Securities Markets Efficient?

Elements of Market Efficiency Uniform availability and costless dissemination of information Prices always fully reflect all available information Low to non-existent transactions costs Perfectly liquid markets

Is The Market Efficient? Two Components: What is the Relevant Information? How much should it change market values? Leads to a joint hypothesis problem: Cannot test market efficiency independently of some model for how securities should be valued

Forms Of EMT Weak Form Technical Analysis Prices reflect all historical information Price changes follow a random walk (over all time horizons) Semi-Strong Form Fundamental Analysis Prices reflect all public information Strong Form Insider Trading Prices reflect all public and private information

Evidence on EMT Weak Form Tests for Return Predictability Pro: Con: Louis Bachelier (1900) – French capital markets Maurice Kendall (1953) – British stocks Con: Various violations of normal random walk Seasonality Overreaction poor performers do better

Evidence on EMT Semi-Strong Form Event Studies Pro: Performance of fund managers 70% or more outperformed by market Con: Some money managers consistently outperform “The Superinvestors of Graham and Doddsville” Accounting and Event Anomalies Low P/E effect Low Market/Book ratio effect Firm size effect

Evidence on EMT Strong Form Tests for Private Information Pro: Con: ??? Con: Insider purchases Share repurchases

Summary Is the Market Efficient? Much evidence consistent with market efficiency Markets seem hard to beat by professionals But also many anomalies contrary to efficiency Two alternative viewpoints: Michael Mauboussin Security Analysis professor at Columbia Business School; managing director at CSFB Robert A. Haugen Emeritus Professor of Finance at U.C., Irvine; Founding partner, Haugen Custom Financial Systems

Mauboussin’s View www.capatcolumbia.com Market efficiency as a “stretched” paradigm Fama – “I think the crash in ’87 was a mistake” Market as Complex Adaptive System More realistic paradigm Markets constantly evolving as participants search for new ways to anticipate the future, learning new rules (but forgetting old ones!) Market’s evolution not “random,” but not predictable either, for the most part Market as “effectively” efficient

Mauboussin’s View But: Potential sources for value-added: Information Analysis / Valuation Exploiting psychological biases of investors (?) Primacy of security analysis Back to basics Cut through Gordian knot of trying to anticipate what all the other investors will anticipate that the market as a whole will anticipate Over time, stock market values tend to track business values, despite short-term trips away from this foundation of value Warren Buffett approach

Haugen’s View www.haugensystems.com Market efficiency as a “religion” Markets as Inefficient “The Wrong 20-Yard Line” Still hard to beat due to extensive “noise” Need to make best use of available tools Ad hoc factor model For determining expected returns and covariances Markowitz portfolio optimization For best combining the stocks into a portfolio Primacy of portfolio analysis

Haugen’s View Primacy of Portfolio Analysis Quantitative analysis for determining stock expected returns and covariances Portfolio as the primary unit of analysis Not concerned about characteristics of individual stocks, per se, but with what they contribute to the overall portfolio Caesar salad analogy No single ingredient tastes like the completed salad, so don’t screen for specific ingredients that do Each different contributes to the overall taste Water analogy Don’t learn about characteristics of H2O by studying characteristics of Hydrogen and Oxygen

My View Market “efficiency” as an irrelevant question Ultimately, no objective way of saying whether the market is efficient (cf., joint hypothesis problem) Are stocks “correctly” valued? “Of value to whom, and for what?” Key question – can you beat the market? “More than one way to skin a cat” Conceptually, tend towards Mauboussin’s view In practice, tend towards Haugen’s view Suits my comparative advantage! Is there any common ground?

My View Is there any common ground? Both agree with the need for a new paradigm Complex Adaptive System Theory vs. “The New Finance” Both agree on the importance of taking investor psychology (“behavioral finance”) into account Interestingly, despite following radically different approaches, both tend the favor the same types of companies Chaos and fractal theory could also provide some additional common ground

Background: The evolution of academic finance.

The Evolution of Academic Finance The Old Finance 1930’s 40’s 50’s 60’s 70’s 80’s 90’s beyond The Old Finance Theme: Analysis of Financial Statements and the Nature of Financial Claims Paradigms: Security Analysis Uses and Rights of Financial Claims (Graham & Dodd) (Dewing) Foundation: Accounting and Law

The Evolution of Academic Finance The Old Finance Bob goes to college 1930’s 40’s 50’s 60’s 70’s 80’s 90’s beyond Modern Finance Modern Finance Theme: Valuation Based on Rational Economic Behavior Paradigms: Optimization Irrelevance CAPM EMH (Markowitz) (Modigliani & Miller) (Sharpe, Lintner & Mossen) (Fama) Foundation: Financial Economics

The Evolution of Academic Finance The Old Finance Bob goes to college The New Finance 1930’s 40’s 50’s 60’s 70’s 80’s 90’s beyond Modern Finance “The New Finance” Theme: Inefficient Markets Paradigms: Inductive ad hoc Factor Models Behavioral Models Expected Return Risk (Haugen) (Chen, Roll & Ross) (Kahneman & Tversky) Foundation: Statistics, Econometrics, and Psychology