1. Chapter 12 Efficient Market Hypothesis

2. CHAPTER 12 OVERVIEW 12.1Efficient Market Concept 12.2Efficient Market Hypothesis 12.3Time Series Index of Stock Prices 12.4Random Walk Theory 12.5Failures of Technical Analysis 12.6Measuring Relative Performance 12.7Professional Investment Management

3. Efficient Market Concept  Information is Power:  Street professionals seek bargain stocks 24/7  information is serious business  Coin Flipping Contest: investment metaphor for gambling  short-term speculation in stocks and bonds = buying lottery tickets  winning tips are probably wrong

4. Efficient Markets  In an efficient stock market, the price for any given stock effectively represents the expected net present value of all future profits  Interplay of supply and demand sets prices  Price for any stock or bond represents collective wisdom about future prospects

5. Efficient Markets Hypothesis  EMH holds that security prices fully reflect all available information at any time.  Individual and professional investors buy and sell stocks under assumption that intrinsic value differs from market price.  Perfectly competitive securities market:  New information arrives at market independently and randomly.  Both buyers and sellers adjust rapidly to new info.  Current security prices reflect all relevant risk/return info.

6. Levels of Market Efficiency  Weak-Form Hypothesis: current prices reflect all stock market information; trading rules based on past stock market return or volume are futile.  Semistrong-Form Hypothesis: current prices reflect all public information; trading rules based on public information are futile.  Strong-Form Hypothesis: current prices reflect all public information and non-public information. All trading rules are futile.

7. Public vs. Private Information  Stock Market Information: stock price and trading volume figures  Public Information: freely shared information  Nonpublic Information: proprietary data  Insider Information: proprietary information within a firm

8. Time Series of Stock Prices  Time Series: date points over time  Correlation among stock indexes is strong.  Daily Returns: stock prices change irregularly  Daily returns are noisy (highly variable) and random around a mean of zero  Distribution of daily returns is normal; follows bell-shaped curve  Booms and Busts: reversion to the mean in day-to-day trading doesn’t work

9. Random Walk Theory  Random Walk: irregular pattern of numbers that defies prediction  Random Walk Theory: concept that stock price movements do not follow any pattern or trend  Fair Game: even bet; 50-50 chance  Random Walk With Drift: slight upward bias to inherently unpredictable daily stock prices DJIA Prices

10. Evidence supports notion of random walk Random Walk Research Figure 12.4

11. KEY TERMS Technical Analysis  Technical Analysis  Chartists  Out-of-Sample Experiments  Data-Snooping Problem  Back Testing

12. EMH & Technical Analysis  Tech Analysis: examining historical date on stock prices and trading volume to predict future prices  Chartist: practitioner of technical analysis Almost all studies indicate that such focus on past trends is worthless

13. FAILURES OF TECHNICAL ANALYSIS Data-Snooping Problem  Data-Snooping Problem: reliance on chance observations in historical data as guide to investment decision making.  Out-of-Sample Experiment: test of any historically useful technical trading rule over some new sample of data that was not used to derive that rule  Back Testing: backward-looking analysis

14. FAILURES OF TECHNICAL ANALYSIS Believing-is-Seeing Problem  Eager to believe in the possibility of beating the market, investors sometimes “see” results that do not really exist.  There is no robust (conclusive) evidence that technical trading rules can enhance investor or trader profits.

15. Measuring Relative Performance  Investment Dartboard: a blindfolded chimpanzee throwing darts at The Wall Street Journal could do as well as experts in picking stocks. Investors are better off buying an index fund that simply buys and holds a widely diversified portfolio of common stocks.

16. Investment Performance Benchmarks  Standards to compare performance  Major Indexes:  S&P 500: market value-weighted; 500 blue-chips; broadly representative  Wilshire 4500: mid-cap proxy  Russell 2000: small-cap proxy  MSCI EAFE: foreign stock market proxy  Lehman Brothers Aggregate Bond Index

17. Beating the Market  Superior portfolio performance  beating the market in terms of earning above-market investment returns with marketlike risk  earning marketlike returns from a portfolio with below-market risk  To measure risk and return: Style Box

18. Morningstar’s Innovative Nine-Part Style Boxes Allow Investors to Characterize Portfolio Risk & Return Table 12.5

19. Morningstar’s Innovative Nine-Part Style Boxes Allow Investors to Characterize Portfolio Risk & Return  Approximate technique  Separate Funds based on the median stock holdings market capitalization  Calculate the median P/E and M/B ratios for each size fund.  Normalize each fund by the median fund size

20. Professional Investment Management  A loser’s game?  Impossible to beat the market over the longer term.  If portfolio management had no costs, management fees, commissions,sales loads, operating expenses, etc., returns as a whole would match the market.  Zero Sum Game: one investor’s gain is another investor’s loss

21. Managed Portfolio Performance  Financial information readily available.  Today’s top-performing mutual fund becomes tomorrow’s average or underperformer.  Index funds outperform many comparable actively-managed funds.  Overwhelming evidence for EMH suggests that best strategy is index funds.

22. Investment Professionals’ Role  Tailoring to investors’ tax considerations and risk profiles  Age, tax bracket, risk aversion, employment status  Investment professionals and media hostile to EMH  If every investor believed the EMH, no one would analyze markets and the market would cease to be efficient.

23. KEY TERMS Efficient Market Hypothesis  coin-flipping contest  efficient market  efficient market hypothesis  weak-form hypothesis  stock market information  semistrong-form hypothesis  public information  strong-form hypothesis  nonpublic information  insider information  time series  normal distribution  random walk  random walk theory  fair game  random walk with drift  believing-is-seeing problem  investment benchmark  style box  zero-sum game