1. Investments and Portfolio Management
WEEK 10 1

2. Efficient Capital Markets
Objectives :
Explain the term ‘efficient capital market’
Discuss the factors that contribute to an efficient market
Discuss the three sub hypotheses of efficient markets
Evaluate EMH in light technical analysis, fundamental analysis, portfolio management and behavioural finance 2

3. Can you beat the market? 3

4. What is an efficient market?
According to Fama (1965), markets are considered to be efficient relative to a given information set if there are no abnormal profit opportunities for investors trading on the basis of this information.
So, in simple terms, efficient markets can be defined as those where all available information are fully reflected in the share price at any time.
NB. Efficient market hypothesis (EMH) refers to “informational” efficiency rather than other forms of efficiency 4

5. Assumptions for an efficient capital market
There are a large number of profit-maximising participants independantly analysing and valuing securities
New information about securities comes to the market in a random fashion
The buy and sell decisions of all profit-maximising investors cause security prices to adjust rapidly to reflect any new information
Therefore, security prices at any one point in time should reflect all currently available information. The expected returns implicit in the security price should reflect its risk. 5

6. Efficient Market Hypotheses (EMH)
Random Walk Hypothesis
– Changes in security prices occur randomly i.e. there are no patterns or trends
Efficient Market Hypothesis (EMH)
Divided into three sub-hypotheses; weak, semi- strong and strong form 6

7. Random Walk
A random walk is one in which future steps or directions cannot be predicted on the basis of past actions.“
Burton G. Malkiel. 7

8. Random Walk
Future changes in stock prices should, for all practical purposes, be unpredictable
If stock is predicted to rise, people will buy to equilibrium level; if stock is predicted to fall, people will sell to equilibrium level
Thus, if stock prices were predictable, thereby causing the above behaviour, price changes would be near zero, which has not been the case historically 8

9. Measures of market efficiency (Fama)
Weak Form
Semi-strong Form
Strong Form 9

10. Weak-Form EMH
All current stock prices reflect all security market information.
Past rates of return and market historical data should have no relationship with future rates of return.
Any effort spent by professional technical analysts to examine historic price movements will be useless. 10

11. Semi-strong-Form EMH
Security prices will adjust rapidly to the release of all public information (includes weak-form plus non-market information).
Fundamental analysis based upon new information after it is public is of no use, e.g. the estimation of factors such as the growth of a firm in order to define stock’s intrinsic value is ineffective as this information is available to everyone.
The security price should immediately reflect all new public information. 11

12. Strong-Form EMH
Stock prices fully reflect all information from both public and private sources. Assumes a ‘perfect market’.
No investor has access to proprietary information and cannot, therefore, make above-average returns.
Significant legal implications with regards to internal trading regulations. 12

13. 1313
Security Analysts
Tests have considered whether it is possible to identify a set of analysts who have the ability to select undervalued stocks
The analysis involves determining whether, after a stock selection by an analyst is made known, a significant abnormal return is available to those who follow their recommendations
There is evidence in favour of the existence of superior analysts who apparently appear to have both market timing and stock-picking ability
Best Wall Street Analysts 13

14. Professional Money Managers
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Trained professionals, working full time in investment management
If any investor can achieve above-average returns, it should be this group
If any non-insider can obtain inside information, it would be this group due to the extensive management interviews that they conduct
Most tests examine mutual funds
Risk-adjusted, after expenses, returns of mutual funds generally show that most funds did not beat aggregate market performance 14

15. Corporate Insider Trading
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Corporate Insider Trading
Corporate insiders include major corporate officers, directors, and owners of 10% or more of any equity class of securities. Insider trading is illegal in the UK.
In the US, insiders must report to the SEC each month on their transactions in the stock of the firm for which they are insiders
These insider trades are made public about six weeks later and allowed to be studied
Corporate insiders generally experience above-average profits especially on purchase transactions 15

16. Corporate Insider Trading
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Corporate Insider Trading
This implies that many insiders had private information from which they derived above-average returns on their company stock 16

17. Evidence on Efficient Market Hypothesis
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Evidence on Efficient Market Hypothesis
In “A random walk down Wall Street”
(1973) economist Burton Malkiel states "a blindfolded monkey throwing darts at a newspaper's financial pages could select a portfolio that would do just as well as one carefully selected by experts." 17

18. EMH & Technical Analysis
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EMH & Technical Analysis
Technical analysis is a method of evaluating securities by analysing statistics generated by market activity.
Buy, hold and sell decisions are then made as a result of the findings of the analysis.
There are many different “trading rules” used by analysts, depending on their own findings
The basic premise of technical analysis is that the information dissemination process is slow thus the adjustment of prices is not immediate but forms a pattern. 18

19. Should Technical Analysis beat EMH?
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This view is diametrically opposed to the concept of efficient capital markets that contends that there is a rapid dissemination process and, therefore, prices reflect all information.
Thus, there would be no value in technical analysis because technicians act after the news is made public which would negate its value in an efficient market.
In a weak-form, or even semi-strong-form efficient market where all market information is reflected in security prices, technical analysis of market and trading data can have no value. 19

20. EMH and Fundamental Analysis
Fundamental analysis suggests that the intrinsic value of the aggregate market, an industry or an individual investment at a point in time depends on underlying economic factors.
Economic factors may include future earnings, cash flows, interest rates and risk variables.
Buy – market price is below intrinsic value
Sell (do not buy) – market price is above intrinsic value
By superior estimation of intrinsic values an investor can make above-average returns. 20

21. Should Fundamental Analysis beat EMH?
Analysis of historical data alone is of little use as it is available to everyone.
Superior returns achieved from better (and correct) estimates of relevant valuation variables and their impact on industries and individual investments.
For estimates to achieve superior returns they must be different to the consensus.
There are ‘superior’ analysts who are able to do this. 21

22. Aggregate Market Analysis
EMH implies that examining only past economic events is not likely to lead to outperforming a buy-and- hold policy because the market adjusts rapidly to known economic events
Merely using historical data to estimate future values is not sufficient
You must estimate the relevant variables that cause long-run movements 22

23. EMH and Portfolio Management
Evidence suggests that money managers cannot beat the market.
This could be because research uses the recommendations of both superior and inferior analysts that then cancel each other out.
This raises the question of whether portfolios should be actively or passively managed???
A portfolio should be actively managed if the money manager has access to superior analysts
Without superior analysts money managers should build a diversified portfolio in line with their clients risk preferences
This has given rise to the increased use of index funds and ETF’s. 23

24. What about individual behaviour???
Are all investors fully rational and always seeking profit maximization?
What about individual behaviour???
Behavioural Finance
‘…seeks to understand and predict systematic financial market implications of psychological decisions processes… behavioral finance is focused on the implication of psychological and economic principles for the improvement of financial decision-making.’
(Olsen, 1998, cited in Reilly and Brown, 2012) 24

25. Behavioural Finance - Biases
Hold ‘losers’ too long and sell ‘winners’ too soon
Investors fear losses more than they value gains
Loss aversion
Clinging to initial opinions too tightly for too long
Reluctant to search for contradictory beliefs
Sceptical or misinterpret alternative views
Belief perseverance
Overestimation of growth rates and duration for growth companies
Overemphasise good news and ignore bad news
Overconfidence
Put more money into a stock that has declined from initial purchase
Seen as a bargain
Escalation bias 25

26. Behavioural Finance - Biases
A belief that success is due to own talent but failures due to ‘bad luck’
That is, an overestimation of your own talent
Self-attribution bias
Seeking and using information to support previous opinions and decisions
A belief that you ‘predicted it’ after the event
Confirmation & Hindsight bias
Non-professionals all move together when there is a shift in sentiment
The ‘herd’ nearly always wrong causing volatility
Noise traders
A combination of ‘fundamental value’ and ‘investor sentiment’
View market price in relation to it’s intrinsic value
Fusion trading 26

27. Summary - Evidence in favour of Efficient Market Hypothesis
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Summary - Evidence in favour of Efficient Market Hypothesis
Stock prices reflect publicly available info: anticipated announcements don't affect stock price
Technical analysis does not consistently outperform market
Fundamental analysis can produce ‘superior analysts’ who can estimate better and differently to the consensus
Behavioural factors can introduce volatility into markets with ‘irrational’ investment behaviour. 27

28. Reading 2828 The slides for this week’s lecture have been based on: 28
Reilly, F. K. and Brown, K. C. (2012) Analysis of Investments and Management of Portfolios, 10th edition, Cengage Learning – Chapter 6
Additional reading includes:
E. Fama (1970) Efficient capital markets: a review of theory and empirical work
Dong, Bowers and Latham (2013) Evidence on the efficient market hypothesis from 44 Global Financial Market Indexes.
Burton G. Mickiel (1973) A random walk down wall street,
Burton G. Mickiel (2005) Reflections on the efficient market hypothesis: 30 years later 28