1. McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Efficient Markets & The Behavioral Critique CHAPTER 8

2. 8-2 Efficient Market Hypothesis (EMH) Do security prices reflect information ? Why look at market efficiency –Implications for business and corporate finance –Implications for investment

3. 8-3 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. 8-4 SecurityPrices Time Random Walk with Positive Trend

5. 8-5 Why are price changes random? –Prices react to information –Flow of information is random –Therefore, price changes are random Random Price Changes

6. 8-6 EMH and Competition Stock prices fully and accurately reflect publicly available information Once information becomes available, market participants analyze it Competition assures prices reflect information

7. 8-7 Figure 8-1 Cumulative Abnormal Returns Surrounding Takeover Attempts

8. 8-8 Figure 8-2 Returns Following Earnings Announcements

9. 8-9 Forms of the EMH WeakSemi-strongStrong

10. 8-10 Types of Stock Analysis 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

11. 8-11 Active Management –Security analysis –Timing Passive Management –Buy and Hold –Index Funds Implications of Efficiency for Active or Passive Management

12. 8-12 Even if the market is efficient a role exists for portfolio management Even if the market is efficient a role exists for portfolio management Appropriate risk level Tax considerations Other considerations Market Efficiency and Portfolio Management

13. 8-13 Event studies Assessing performance of professional managers Testing some trading rule Empirical Tests of Market Efficiency

14. 8-14 1. Examine prices and returns over time How Tests Are Structured

15. 8-15 0+t-t Announcement Date Returns Surrounding the Event

16. 8-16 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.)

17. 8-17 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.)

18. 8-18 Magnitude Issue Selection Bias Issue Lucky Event Issue Issues in Examining the Results

19. 8-19 Tests of Weak Form Returns over short horizons –Very short time horizons small magnitude of positive trends –3-12 month some evidence of positive momentum Returns over long horizons – pronounced negative correlation Evidence on Reversals

20. 8-20 Small Firm Effect (January Effect) Neglected Firm Market to Book Ratios Post-Earnings Announcement Drift Higher Level Correlation in Security Prices Tests of Semi-strong Form: Anomalies

21. 8-21 Figure 8-3 The Size Effect from 1926 to 2003

22. 8-22 Figure 8-4 Average Rate of Return as a Function of Book to Market

23. 8-23 Figure 8-5 Cumulative Abnormal Returns in Response to Earnings Announcements

24. 8-24 Implications of Test Results Risk Premiums or market inefficiencies Anomalies or data mining Behavioral Interpretation –Inefficiencies exist –Caused by human behavior

25. 8-25 The Behavioral Critique Information Processing Behavioral Biases Limits to Arbitrage

26. 8-26 Information Processing Forecasting errors OverconfidenceConservatism Sample size neglect and representativeness

27. 8-27 Behavioral Biases Framing Mental accounting Regret avoidance

28. 8-28 Limits to Arbitrage Fundamental risk Implementation costs Model risks

29. 8-29 Mutual Fund and Professional Manager Performance Some evidence of persistent positive and negative performance Potential measurement error for benchmark returns –Style changes –May be risk premiums Superstars

30. 8-30 Figure 8-6 Estimates of Individual Mutual Fund Alphas

31. 8-31 Figure 8-7 Persistence of Mutual Fund Performance