1. Are Securities Markets Efficient?

2. Elements of Market Efficiency
Uniform availability and costless dissemination of information
Prices always fully reflect all available information
Low to non-existent transactions costs
Perfectly liquid markets

3. Is The Market Efficient?
Two Components:
What is the Relevant Information?
How much should it change market values?
Leads to a joint hypothesis problem:
Cannot test market efficiency independently of some model for how securities should be valued

4. Forms Of EMT Weak Form Technical Analysis
Prices reflect all historical information
Price changes follow a random walk (over all time horizons)
Semi-Strong Form Fundamental Analysis
Prices reflect all public information
Strong Form Insider Trading
Prices reflect all public and private information

5. Evidence on EMT Weak Form Tests for Return Predictability Pro: Con:
Louis Bachelier (1900) – French capital markets
Maurice Kendall (1953) – British stocks
Con:
Various violations of normal random walk
Seasonality
Overreaction
poor performers do better

6. Evidence on EMT Semi-Strong Form Event Studies Pro:
Performance of fund managers
70% or more outperformed by market
Con:
Some money managers consistently outperform
“The Superinvestors of Graham and Doddsville”
Accounting and Event Anomalies
Low P/E effect
Low Market/Book ratio effect
Firm size effect

7. Evidence on EMT Strong Form Tests for Private Information Pro: Con:
???
Con:
Insider purchases
Share repurchases

8. Summary Is the Market Efficient?
Much evidence consistent with market efficiency
Markets seem hard to beat by professionals
But also many anomalies contrary to efficiency
Two alternative viewpoints:
Michael Mauboussin
Security Analysis professor at Columbia Business School; managing director at CSFB
Robert A. Haugen
Emeritus Professor of Finance at U.C., Irvine; Founding partner, Haugen Custom Financial Systems

9. Mauboussin’s View www.capatcolumbia.com
Market efficiency as a “stretched” paradigm
Fama – “I think the crash in ’87 was a mistake”
Market as Complex Adaptive System
More realistic paradigm
Markets constantly evolving as participants search for new ways to anticipate the future, learning new rules (but forgetting old ones!)
Market’s evolution not “random,” but not predictable either, for the most part
Market as “effectively” efficient

10. Mauboussin’s View But: Potential sources for value-added:
Information
Analysis / Valuation
Exploiting psychological biases of investors (?)
Primacy of security analysis
Back to basics
Cut through Gordian knot of trying to anticipate what all the other investors will anticipate that the market as a whole will anticipate
Over time, stock market values tend to track business values, despite short-term trips away from this foundation of value
Warren Buffett approach

11. Haugen’s View www.haugensystems.com Market efficiency as a “religion”
Markets as Inefficient
“The Wrong 20-Yard Line”
Still hard to beat due to extensive “noise”
Need to make best use of available tools
Ad hoc factor model
For determining expected returns and covariances
Markowitz portfolio optimization
For best combining the stocks into a portfolio
Primacy of portfolio analysis

12. Haugen’s View Primacy of Portfolio Analysis
Quantitative analysis for determining stock expected returns and covariances
Portfolio as the primary unit of analysis
Not concerned about characteristics of individual stocks, per se, but with what they contribute to the overall portfolio
Caesar salad analogy
No single ingredient tastes like the completed salad, so don’t screen for specific ingredients that do
Each different contributes to the overall taste
Water analogy
Don’t learn about characteristics of H2O by studying characteristics of Hydrogen and Oxygen

13. My View Market “efficiency” as an irrelevant question
Ultimately, no objective way of saying whether the market is efficient (cf., joint hypothesis problem)
Are stocks “correctly” valued?
“Of value to whom, and for what?”
Key question – can you beat the market?
“More than one way to skin a cat”
Conceptually, tend towards Mauboussin’s view
In practice, tend towards Haugen’s view
Suits my comparative advantage!
Is there any common ground?

14. My View Is there any common ground?
Both agree with the need for a new paradigm
Complex Adaptive System Theory vs.
“The New Finance”
Both agree on the importance of taking investor psychology (“behavioral finance”) into account
Interestingly, despite following radically different approaches, both tend the favor the same types of companies
Chaos and fractal theory could also provide some additional common ground

15. Background:
The evolution of academic finance.

16. The Evolution of Academic Finance
The Old Finance
1930’s
40’s
50’s
60’s
70’s
80’s
90’s
beyond
The Old Finance
Theme: Analysis of Financial Statements and the Nature of Financial Claims
Paradigms: Security Analysis Uses and Rights of Financial Claims
(Graham & Dodd) (Dewing)
Foundation: Accounting and Law

17. The Evolution of Academic Finance
The Old Finance
Bob goes
to college
1930’s
40’s
50’s
60’s
70’s
80’s
90’s
beyond
Modern Finance
Modern Finance
Theme: Valuation Based on Rational Economic Behavior
Paradigms: Optimization Irrelevance CAPM EMH
(Markowitz) (Modigliani & Miller) (Sharpe, Lintner & Mossen) (Fama)
Foundation: Financial Economics

18. The Evolution of Academic Finance
The Old Finance
Bob goes
to college
The New Finance
1930’s
40’s
50’s
60’s
70’s
80’s
90’s
beyond
Modern Finance
“The New Finance”
Theme: Inefficient Markets
Paradigms: Inductive ad hoc Factor Models Behavioral Models
Expected Return Risk
(Haugen) (Chen, Roll & Ross) (Kahneman & Tversky)
Foundation: Statistics, Econometrics, and Psychology