1. McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12 Market Efficiency and Behavioral Finance

2. 12-2 Do security prices reflect information ? Why look at market efficiency? Implications for business and corporate finance Implications for investment Efficient Market Hypothesis (EMH)

3. 12-3 Random Walk - stock prices are random Actually submartingale Expected price is positive over time Positive trend and random about the trend Random Walk and the EMH

4. 12-4 Random Walk with Positive Trend Security Prices Time

5. 12-5 Why are price changes random? Prices react to information Flow of information is random Therefore, price changes are random Random Price Changes

6. 12-6 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

7. 12-7 Weak Semi-strong Strong Forms of the EMH

8. 12-8 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

9. 12-9 Active Management Security analysis Timing Passive Management Buy and Hold Index Funds Active or Passive Management

10. 12-10 Even if the market is efficient a role exists for portfolio management: Appropriate risk level Tax considerations Other considerations Market Efficiency & Portfolio Management

11. 12-11 Event studies Assessing performance of professional managers Testing some trading rule Empirical Tests of Market Efficiency

12. 12-12 1. Examine prices and returns over time How Tests Are Structured

13. 12-13 Returns Over Time 0+t-t Announcement Date

14. 12-14 2. Returns are adjusted to determine if they are abnormal. Market Model approach a. R t = a t + b t R mt + e t (Expected Return) b. Excess Return = (Actual - Expected) e t = Actual - (a t + b t R mt ) How Tests Are Structured (cont’d)

15. 12-15 2. Returns are adjusted to determine if they are abnormal. Market Model approach c. Cumulate the excess returns over time: 0+t-t How Tests Are Structured (cont’d)

16. 12-16 Magnitude Issue Selection Bias Issue Lucky Event Issue Possible Model Misspecification Issues in Examining the Results

17. 12-17 Technical Analysis Short horizon Long horizon Fundamental Analysis Anomalies Exist What Does the Evidence Show?

18. 12-18 Small Firm Effect (January Effect) Neglected Firm Market to Book Ratios Reversals Post-Earnings Announcement Drift Anomalies

19. 12-19 Explanations of Anomalies May be risk premiums Behavioral Explanations Information Processing Errors Behavioral Biases Limits to Arbitrage

20. 12-20 Information Processing Forecasting Errors Overconfidence Conservatism Sample Neglect and Representativeness

21. 12-21 Behavioral Biases Framing Mental Accounting Regret Avoidance

22. 12-22 Limits to Arbitrage Fundamental Risk Implementation Costs Model Risk

23. 12-23 Some evidence of persistent positive and negative performance. Potential measurement error for benchmark returns. Style changes May be risk premiums Superstar phenomenon Mutual Fund Performance