Market Efficiency and Behavioral Finance Chapter 12
Efficient Market Hypothesis (EMH) Do security prices reflect information ? Why look at market efficiency? Implications for business and corporate finance Implications for investment
Random Walk and the EMH Random Walk - stock prices are random Actually submartingale Expected price is positive over time Positive trend and random about the trend
Random Walk with Positive Trend Security Prices Time
Random Price Changes Why are price changes random? Prices react to information Flow of information is random Therefore, price changes are random
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.
Forms of the EMH Weak Semi-strong Strong
Types of Stock Analysis 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
Active or Passive Management Active Management Security analysis Timing Passive Management Buy and Hold Index Funds
Market Efficiency & Portfolio Management Even if the market is efficient a role exists for portfolio management: Appropriate risk level Tax considerations Other considerations
Empirical Tests of Market Efficiency Event studies Assessing performance of professional managers Testing some trading rule
How Tests Are Structured 1. Examine prices and returns over time
Returns Over Time -t +t Announcement Date
How Tests Are Structured (cont’d) 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: -t +t
Issues in Examining the Results Magnitude Issue Selection Bias Issue Lucky Event Issue Possible Model Misspecification
What Does the Evidence Show? Technical Analysis Short horizon Long horizon Fundamental Analysis Anomalies Exist
Anomalies Small Firm Effect (January Effect) Neglected Firm Market to Book Ratios Reversals Post-Earnings Announcement Drift
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
Mutual Fund Performance Some evidence of persistent positive and negative performance. Potential measurement error for benchmark returns. Style changes May be risk premiums Superstar phenomenon