©2015, College for Financial Planning, all rights reserved. Session 7 Efficient Market Hypothesis (EMH) and Behavioral Finance CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAM Investment Planning

Session Details Module3 Chapter(s)2, 3 LOs3-5 Explain the three forms of the efficient market hypotheses and distinguish among arguments supporting and opposing the EMH. 3-6 Evaluate and explain stock market anomalies. 3-7 Appraise efficient market hypothesis concepts as they relate to other investment theories and behavioral finance. 7-2

Optimal Portfolio E(R i ) SiSi X U1U1 U2U2 U3U3 U4U4 7-3

The Efficient Market Hypothesis Hard to beat the market on a risk- adjusted basis consistently Outperforming the market is not just earning a higher return Considering risk is also important 7-4

Efficient Markets Assumptions Large number of competing participants Information readily available Small transaction costs 7-5

Random Walk It does not mean prices are random. Successive price changes are independent. Today's price does not forecast tomorrow's price (so technical analysis does not work). Current price embodies all known information. 7-6

Forms of Efficient Market Hypothesis Strong Semi-strong Weak 7-7

The Strong Form Investor cannot outperform the market under any circumstances. Not even inside information enables an investor to outperform the market. 7-8

The Semi-Strong Form Inside information may lead to superior returns. Studying economic and accounting data will not lead to superior investment returns. 7-9

The Weak Form Fundamental analysis may lead to superior returns. Technical analysis will not help (remember that technical analysis will not work for any of the forms of EMH). 7-10

Different Markets – Different Efficiencies How efficient (or inefficient) are the following markets? Large-cap U.S. stocks Large-cap international stocks Small-cap U.S. stocks Small-cap international stocks Emerging market stocks Emerging market bonds U.S. corporate bonds U.S. government bonds U.S. municipal bonds International corporate bonds International government bonds 7-11

Anomalies Empirical results generally support o the weak form, and o the semi-strong form Possible exceptions to the efficient market hypothesis, called anomalies, appear to exist. 7-12

Efficient Market Anomalies P/E effect Book Value/Market Value effect Small-firm effect Neglected-firm effect Value Line phenomenon 7-13

Technical Analysis Indicators These are not valid under EMH since they are technical indicators Odd-lot sales Mutual fund cash positions Investment advisory opinions Put/call ratio Barron’s Confidence Index 7-14

Behavioral Finance Behavioral finance challenges one of the major assumptions of the EMH, namely that investors are rational! Recognizing common mistakes can help both the advisor and the investor make better decisions. 7-15

Behavioral Finance (1) Loss Aversion Fear of Regret Overconfidence (Optimism Bias) Representativeness Framing Rationalization (Confirmation Bias) 7-16

Behavioral Finance (2) Hindsight Bias Self-Attribution Bias Anchoring Recency Mental Accounting Status Quo Bias Illusion of Control Endowment Bias 7-17

Question 1 The efficient market hypothesis (EMH) makes all of the following assumptions, except a.an investor cannot underperform or outperform the market. b.securities cannot be undervalued or overvalued. c.historical information is fully reflected in the price of a security; information that provides guidance on future prices. d.an investor can earn a return commensurate with the amount of risk being taken; no more, no less. 7-18

Question 2 John does not believe he can outperform the market, so he invests exclusively in index funds. He believes the only way one could “beat the market” would be by knowing and using non-public inside information. John believes in the a.weak form of the efficient market hypothesis. b.semi-weak form of the efficient market hypothesis. c.strong form of the efficient market hypothesis. d.semi-strong form of the efficient market hypothesis. 7-19

Question 3 Your client has been told the following information. Which statement would you advise him is false? a.Most analysts believe that some markets are more efficient than others (such as U.S. stocks compared with emerging market stocks). b.The efficient market hypothesis is consistent with behavioral finance. c.The less efficient a market is, the more potential there may be for discovering undervalued securities. d.Overconfidence in one’s ability to “read” the market can lead to overtrading. 7-20

Question 4 Which one of the following is not a stock market anomaly? a.BV/MV b.neglected firm c.Value Line d.Morningstar 7-21

Question 5 Belinda follows and charts the price and volume for various securities. You can interpret that she a.does not believe in the EMH. b.believes in the weak form of the EMH. c.believes in the semi-strong from of the EMH. d.believes in the strong form of the EMH. 7-22

Question 6 Fred has been an investor for over 30 years and strongly believes that the market “will always come back” and dismisses any possibility that “this time things may be different.” He invests in both bull and bear markets taking a long-term perspective. Which one of the behavioral biases is Fred closest to exhibiting? a.confirmation b.regret aversion c.status quo d.strategic 7-23

Question 7 Simon inherited some bank stock from his mother, and will not sell any of it even though it now represents a substantial percentage of his portfolio, nearly 30%. He tells his advisor that he is not concerned about the shares since it is “found money anyway.” In order to help Simon, you would explain the behavioral finance concept of a.recency. b.hindsight. c.self-attribution. d.mental accounting. 7-24

Question 8 Angela follows the stock market on a daily basis and often trades based upon her “gut’ feeling as to what is the right move to make. She does not consider herself to be a day trader, but since she follows current news and events closely she often trades based upon this information. The market has been trending down for the past year, and she believes that this will continue. Which behavioral biases is Angela displaying the most? I.framing II.overconfidence III.recency IV.endowment a.I and II only b.II and III only c.II and IV only d.III and IV only 7-25

©2015, College for Financial Planning, all rights reserved. Session 7 End of Slides CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAM Investment Planning