McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Efficient Markets & The Behavioral Critique CHAPTE R 8

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 - stock prices are random Actually submartingale Expected price is positive over time Positive trend and random about the trend

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. SecurityPrices Time Random Walk with Positive Trend

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Why are price changes random? Prices react to information Flow of information is random Therefore, price changes are random Random Price Changes

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 8-1 Cumulative Abnormal Returns Surrounding Takeover Attempts

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 8-2 Returns Following Earnings Announcements

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Forms of the EMH Weak Semi-strong Strong

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Active Management Security analysis Timing Passive Management Buy and Hold Index Funds Implications of Efficiency for Active or Passive Management

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Even if the market is efficient a role exists for portfolio management Appropriate risk level Tax considerations Other considerations Market Efficiency and Portfolio Management

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Event studies Assessing performance of professional managers Testing some trading rule Empirical Tests of Market Efficiency

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1.Examine prices and returns over time 2.Returns are adjusted to determine if they are abnormal Market Model approach a. R t = a t + b t R mt + e t (Expected Return) b. Excess Return = (Actual - Expected) e t = Actual - (a t + b t R mt ) 3.Returns are adjusted to determine if they are abnormal How Tests Are Structured

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Magnitude Issue Selection Bias Issue Lucky Event Issue Issues in Examining the Results

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Tests of Weak Form Returns over short horizons Very short time horizons small magnitude of positive trends 3-12 month some evidence of positive momentum Returns over long horizons – pronounced negative correlation Evidence on Reversals

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Small Firm Effect (January Effect) Neglected Firm Market to Book Ratios Post-Earnings Announcement Drift Higher Level Correlation in Security Prices Tests of Semi-strong Form: Anomalies

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 8-3 The Size Effect from 1926 to 2003

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 8-4 Average Rate of Return as a Function of Book to Market

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 8-5 Cumulative Abnormal Returns in Response to Earnings Announcements

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Implications of Test Results Risk Premiums or market inefficiencies Anomalies or data mining Behavioral Interpretation Inefficiencies exist Caused by human behavior

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Behavioral Critique Information Processing Behavioral Biases Limits to Arbitrage

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Information Processing Forecasting errors Overconfidence Conservatism Sample size neglect and representativeness

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Behavioral Biases Framing Mental accounting Regret avoidance

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Limits to Arbitrage Fundamental risk Implementation costs Model risks

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Mutual Fund and Professional Manager Performance Some evidence of persistent positive and negative performance Potential measurement error for benchmark returns Style changes May be risk premiums Superstars

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 8-6 Estimates of Individual Mutual Fund Alphas

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 8-7 Persistence of Mutual Fund Performance