1. Investments, 8 th edition Bodie, Kane and Marcus McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. CHAPTER 11 The Efficient Market Hypothesis & Performance & PerformanceEvaluation

2. Investments, 8 th edition Bodie, Kane and Marcus McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Performance Evaluation

3. 11-3 Performance and the Market Line Risk i E(R i ) M RFRF Risk M E(R M ) ML Undervalued Overvalued Note: Risk is either  or 

4. 11-4 Performance and the Market Line (cont.) Risk i E(R i ) M RFR Risk M E(R M ) ML A B C D E Note: Risk is either  or 

5. 11-5 The Treynor Measure The Treynor measure calculates the risk premium per unit of risk (  i ) Note that this is simply the slope of the line between the RFR and the risk-return plot for the security Also, recall that a greater slope indicates a better risk- return tradeoff Therefore, higher T i generally indicates better performance

6. 11-6 The Sharpe Measure The Sharpe measure is exactly the same as the Treynor measure, except that the risk measure is the standard deviation:

7. 11-7 Sharpe vs Treynor The Sharpe and Treynor measures are similar, but different: –S uses the standard deviation, T uses beta –S is more appropriate for well diversified portfolios, T for individual assets –For perfectly diversified portfolios, S and T will give the same ranking, but different numbers (the ranking, not the number itself, is what is most important)

8. 11-8 Sharpe & Treynor Examples

9. 11-9 Jensen’s Alpha Jensen’s alpha is a measure of the excess return on a portfolio over time A portfolio with a consistently positive excess return (adjusted for risk) will have a positive alpha A portfolio with a consistently negative excess return (adjusted for risk) will have a negative alpha Risk Premium Market Risk Premium 0  > 0  = 0  < 0

10. 11-10 Do security prices reflect information ? Why look at market efficiency? –Implications for business and corporate finance –Implications for investment Efficient Market Hypothesis (EMH)

11. 11-11 Figure 11.1 Cumulative Abnormal Returns Before Takeover Attempts: Target Companies

12. 11-12 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

13. 11-13 Weak Semi-strong Strong Versions of the EMH

14. 11-14 Subsets of available information For a given stock Information in past stock prices All Public Information All Available Information including inside or private information

15. 11-15 3 forms of market efficiency hypothesis Information in past stock prices All Public Information All Available Information including inside or private information Since we are more interested in how efficient is the capital market, we define the following 3 forms of market efficiency hypothesis: “A market is efficient if it reflects ALL available information” [1] Strong-form - ALL available info [2] Semi-strong form - ALL available info [3] Weak-form - ALL available info

16. 11-16 3 forms of market efficiency hypothesis Weak-form “Stock prices are assumed to reflect any information that may be contained in the past history of the stock price itself.” –For example, suppose there exists a seasonal pattern in stock prices such that stock prices fall on the last trading day of the year and then rise on the first trading day of the following year. Under the weak-form of the hypothesis, the market will come to recognize this and price the phenomenon away. –Anticipating the rise in price on the first day of the year, traders will attempt to get in at the very start of trading on the first day. Their attempts to get in will cause the increase in price to occur in the first minutes of the first day. Intelligent traders will then recognize that to beat the rest of the market, they will have to get in late on the last day. The consequences, therefore, is the elimination of the pattern as price in the last trading day should be bid up.

17. 11-17 3 forms of market efficiency hypothesis Semi-strong-form “Stock prices are assumed to reflect any information that is publicly available.” –These include information on the stock price series, as well as information in the firm’s accounting reports, the reports of competing firms, announced information relating to the state of the economy, and any other publicly available information relevant to the valuation of the firm.

18. 11-18 3 forms of market efficiency hypothesis Strong-form “Stock prices are assumed to reflect ALL information, regardless of them being public or private.” –Under this form, those who acquire insider information act on it, buying or selling the stock. Their actions affect the price of the stock, and the price quickly adjusts to reflect the insider information.

19. 11-19 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

20. 11-20 4 basic traits of efficiency An efficient market exhibits certain behavioral traits. We can examine the real market to see if it conforms to these traits. If it doesn’t, we can conclude that the market is inefficient. 1.Act to new information quickly and accurately 2.Price movement is unpredictable (memory-less) 3.No trading strategy consistently beat the market 4.Investment professionals not that professional

21. 11-21 1) Act to news quickly & accurately0+t-t The timing for a positive news Days relative to announcement day Stock price ($)

22. 11-22 1) Act to news quickly & accurately0+t-t Days relative to announcement day Stock price ($) If the market is efficient, 1) at time 0, the positive news come, there is an immediate up in the stock price to the RIGHT level. (i.e., the PINK path) 2) There is no delays in analyzing news and slowly reflecting in the stock price like the ORANGE path does. 3) There is also no over-reaction like the BLUE path does, and then subsequently adjustment back to the correct level.

23. 11-23 2) Memory-less price movement If the market is efficient (WEAK-FORM), 1)The so-called “momentum” is nothing. (Google “Stock momentum”) “momentum” is like, if once started on a downward slide, stock prices develop a propensity to continue sliding. The expected change in today’s price would, in fact, be related (correlated positively) with the price changes in the past. 2) If the market is efficient, prices only move in response to “news”. More precisely, “news” is any discrepancy between the public’s expectation and the actual realized event. E.g, “If everyone expects Wal-Mart’s sales to go up by 50%, and if the news announces that it did go up by 50%, this is not a news. If it goes up by 30% instead, it is a news, a negative one though.” 3) To detect “memory” or “momentum”, we try to see if Cov(ΔP t, ΔP t-i ) is significantly different from zero or not, for i ≠ 0

24. 11-24 3) No superior trading strategies One way to test for market efficiency is to test whether a specific trading rule or investment strategy, would have CONSISTENTLY produced abnormally high return. Problem about such test is: 1.What is abnormal return again? We run into the problem of joint hypothesis testing again in order to find an expected return as benchmark. 2.What kind of information you use to construct an investment strategy? Can you be sure the information you are based on really reflect what WAS available when the decision to invest was made. E.g., Last quarter’s earning is out around February of next year. If a WINNING investment strategy says “invest in the top 10 companies last year by Jan”, it is not an employable strategy. 3.What is the cost of implementing a strategy?

25. 11-25 4) Professionals aren’t that professional If professional investors consistently beat the market, we conclude that the market is not that efficient. If the market is really efficient, we should not see professionals making abnormally high returns. The puzzle is: “we do see professionals having amazing records.” The answer is: “Suppose we take a thousand people in a gigantic stadium. Have them flip coins. Suppose “head” is winning and “tail” is losing. There is no surprise to find a few individual “flippers” with unbelievable records of success and failure. Those having 20 heads in a row goes on TV and showcase their exceptional flipping skills. But we know they’re just plain lucky.”

26. 11-26 So what’s the value for portfolio management If capital markets are efficient, should we just throw darts at the Wall Street Journal instead of trying to rationally choose a stock portfolio? The answer is a big NO. As you have learnt, you need to have a well-diversified portfolio that is tailored towards your risk-preference. Depending on your age, your risk-preference, your current situation, your tax bracket, and all other relevant factors, your portfolio should be carefully constructed. Don’t forget that there is value for diversification. There is value for you to learn options. There is value for you to tailor a future payoff profile specific to your own needs. Throwing darts to pick stocks does not guarantee your specific needs are met.

27. 11-27 So what’s the value for portfolio management The conclusion is: capital market is neither purely efficient nor purely inefficient. The right question to ask is “the degree of efficiency of capital market.” The more efficient capital market is, the better off the society. But even if it is efficient, it doesn’t imply knowledge of finance is useless. Because you have learnt diversification and portfolio theory that is based on maximizing happiness. Price movements are random. But it in NO way implies prices are random. Prices reflect/incorporate available information. The driving force to their random movements is that news comes randomly.