Risk, Return
and Market Efficiency
For 9.220
Chapter 13
Outline
1.
2.
3.
4.
Introduction
Types of Efficiency
Informational Efficiency
Forms of Informational Efficiency and
Empirical Evidence
5. Implications of Informational Efficiency on
Security Price Changes
6. Implications for Investors and Managers
7. Summary and Conclusions
Introduction
 People have various views of how efficient are financial
markets – this is a hotly debated topic, especially
between practitioners and researchers.
 Some argue that since prices change so much and so
quickly, the markets are an irrational crap-shoot that is
not efficient at all. They conclude that only with
professional advice can an investor make wise
investment decisions.
 Others argue that markets are somewhat efficient and
that some professional advice is of low or even negative
value.
 We will look at specific classifications of market efficiency
and review the scientific evidence before making our
judgments.
 Then we will consider the implications of our findings for
security prices, investors, and managers.
Types of Efficiency
1. Operational Efficiency – the processes of buying and
selling securities is fast, accurate, and of low cost.
Mechanisms for transactions are not wasteful.
2. Informational Efficiency – security prices reflect
relevant information (we’ll come back to this in
detail).
3. Allocational Efficiency – capital (money) is allocated
to those users who can use it most efficiently. This
depends on operational efficiency (so there is an easy
flows of funds) and informational efficiency (so people
know what is going on and what investments deserve
their cash).
Informational Efficiency
 Concept: Info is cheaply and widely available to
investors and ALL RELEVANT INFO AVAILABLE IS
ALREADY REFLECTED IN SECURITY PRICES.
 Implication if true: If you know a piece of good info
and you buy a stock because of it, you cannot expect
to make an abnormally high return.
 Why?
 Because that info has already been reflected in the
stock’s price. If it was good info, the stock’s price
would have already risen to reflect the info.
 Therefore, you can only expect to make a normal
return commensurate with the risk of the security.
Info Efficiency – Illustration
 Let Rf = 10%, E[RM] = 16%
 Assume security i has i = 2
 E[Ri] = .10 + 2 [.16-.1] = .22 = 22%
 If yesterday’s closing price of security i is $10, then
the expected price in 1 year is …
$10(1+.22)= $12.20
 Suppose now you get reliable info that says the price
in 1 year should rise to $20.
 When you go to buy that stock what happens?
 The price has already adjusted to reflect the
information – i.e., you are too late!
 Price = ?
= $20/(1+.22)
= $16.39
Ex ante Abnormal Returns
 A stock’s abnormal return is the difference
between its actual return and the expected
return given its risk level.
 Informational efficiency implies you can’t
expect to make an abnormal return – i.e.,
the return you expect (in the probabilistic
sense) to actually make is the same as the
relevant expected return for an asset given
its level of risk.
 Ex ante, expected abnormal returns are zero
Ex post Abnormal Returns
 Look back at the example … what if you bought the
stock yesterday and sold it today?
 Would you have made an abnormal return?
 1-day return is …
= ($16.39-$10.00)/$10.00
= 63.9%
Remember this is a one-day return!
 Obviously this is a high abnormal return!
 Unfortunately, this is after-the-fact (ex post),
yesterday before you had the info, you didn’t expect
to make the abnormal return. And, if you hadn’t
bought the stock until you knew the information, you
were too late.
Understanding Informational Efficiency
 The key part of informational efficiency is
this:
 Prices are not necessarily correct but they are
not consistently wrong in one direction.
 So, even though we know prices will change as
more information is revealed, we don’t know
whether returns will be above or below expected
risk-adjusted returns.
 For practitioners who make their money
giving advice about when to buy which
stocks, talk about informational efficiency
obviously makes them nervous!
What does Info Efficiency say about
the NPV of buying Stocks or Bonds?
 It says NPV = 0.
 Why?
 Because the current price reflects expectations about
future prices and when discounted at the relevant
opportunity cost of capital (the rate adjusted for the
security’s risk), the discounted expected future price
equals the current price.
 Since NPV = PVinflows – PVoutflows
= Discounted future price - current price
= Current price – current price = 0
 What if T-bills have an expected return of 3.5% but
NOVA Corp. shares have an expected return of 12%?
Is the NPV of NOVA’s stock > 0?
 No! The higher expected return is due to the higher
level of systematic risk; NPV = 0 for both.
Forms of Informational Efficiency
 When discussing informational efficiency, it should not
be taken for granted that markets are perfectly
informationally efficient – they are not.
 Finance researchers have looked at what amount of
information is usually reflected in security prices.
 By looking at subsets of information and examining if
the subset of info is usually reflected in security
prices, we can get a better idea of the degree to
which markets are informationally efficient.
 The three forms of info efficiency are related to what
subset of info is reflected in security prices.
 Weak form
 Semi-strong form
 Strong form
Weak Form Informational Efficiency
(WFIE)
 Concept: Current prices reflect all information contained in
the record of past prices (past prices, volume of trades and
dividends)
 Implications: Can’t expect to make abnormal profits (or
returns) by using a stock picking strategy based solely on
past prices or volumes.
 Tests: Look at trading rules to see if they are consistently
profitable given the risk involved.
 filter rules (if stock rises by X% then buy because it will
keep rising, if it falls by X% then sell and go short because
it will keep falling)
 moving average rules, head-and-shoulders, triple-tops, etc.
 these are types of Technical Analysis
 Result: Market does seem to be WFIE after accounting for
transaction costs. Although some anomalies persist:
January effect, day of weak effect, etc.
Semi-Strong Form Informational
Efficiency (SSFIE)
 Concept: Current prices reflect all information that is
publicly available: past prices and volumes other
public information (newspaper info, TV, internet, etc.)
 Implication: Can’t expect to make abnormal returns
by trading based on publicly available information.
 Tests: Look at public announcements of info to see if
abnormal returns could be made following the
announcements.
 Announcements of earnings, stock splits, dividends,
takeovers, etc.
 Results: Any change in stock prices seems to have
anticipated the info release.
 no profits to be made after the info release.
 Market does seem to be SSFIE.
Semi-Strong Form Informational
Efficiency (SSFIE)
 40
Concept:
Current prices reflect all information that is
Cumulative
publicly
available: past prices and volumes other
abnormal
public information (newspaper info, TV, internet, etc.)
35
return %
 30
Implication: Can’t expect to make abnormal returns
by trading based on publicly available information.
 25
Tests: Look at public announcements of info to see if
abnormal returns could be made following the
20
announcements.
15
 Announcements of earnings, stock splits, dividends,
10 takeovers, etc.
 Results: Any change in stock prices seems to have
5
anticipated
the info release.
0 no profits to be made after the info release.
 MarketMonth
doesrelative
seemtoto
be SSFIE.of a stock split
announcement
Source: Fama, Fisher, Jensen and Roll
Semi-Strong Form Informational
Efficiency (SSFIE)
Examine Announcements of events known to have a
price effect. If the market is semi-strong form
efficient, prices will adjust immediately
Events & Findings:
AR  0
Dividend increase
Stock repurchase
AR  0
Floating new shares
AR  0
Takeover announcements (target firm)
AR  0
Insider holding increase
AR  0
Reaction of Stock Price to New Info in Efficient and Inefficient
Markets
Stock
Price ($)
Overreaction and
correction
Delayed reaction
Efficient market reaction
–8 –6 –4 –2
0
+2 +4 +6 +7
Announcement day
Days relative
to announcement day
Strong Form Informational Efficiency
(SFIE)



Concept: Current prices reflect all info: past prices, other public
info, and all private info.
Implication: Can’t expect to make abnormal returns by trading
based on any info.
Tests: Mutual Fund Performance




Specialized managers should be able to get private info (through
research etc.) and thus earn excess returns if market is not SFIE.
Results: after adjusting for the relative riskiness of the funds - no
consistent abnormal returns were found - sometimes lucky
sometimes unlucky 
Would expect, given random chance, about 50% to outperform
some passive portfolio like TSX 300 index (market proxy) and
50% to underperform. This is what happens in reality.
What about insider trading profits? Abnormal Excess Returns are
realized by insiders and are proof that the market is not SFIE.
Note, insider trading is illegal.
Strong Form Informational Efficiency
(SFIE)
Annual Return Performance of Different Types of U.S.


Annual Return Performance

Mutual
Fundsprices
Relative
to aallBroad-Based
Market
Index
Concept:
Current
reflect
info: past prices,
other
public
info, and all private info. (1963-1998)
Implication: Can’t expect to make abnormal returns by trading
based on any info.
0.00%
Tests: Mutual
Performance
All fundsFund
SmallOtherGrowth
Income Growth and Maximum
Sector
aggressive
funds
income
capital
 Specialized company
managers
should be
able tofunds
get private
info (through
-10.00%
research etc.)
and thus
earn excess returns if market
SFIE.
growth
growth
funds is not
gains
funds
funds
funds
 -20.00%
Results: after adjusting
for
the relative riskiness of the funds
funds - no
consistent abnormal returns were found - sometimes lucky
-30.00%
sometimes unlucky 
 Would expect, given random chance, about 50% to outperform
-40.00%
some passive portfolio like TSX 300 index (market proxy) and
50% to underperform. This is what happens in reality.
-50.00%
 What about insider trading profits? These high profits are proof
that the market is not SFIE. Note, insider trading is illegal
-60.00%
although the evidence suggests that this type of crime pays.
Taken from Lubos Pastor and Robert F. Stambaugh, “Evaluating and Investing in Equity Mutual Funds,” unpublished paper, Graduate School
of Business, University of Chicago (March 2000).
Relationship among the Three
Different Information Sets
All information
relevant to a stock
– Strong form
Information set
of publicly available
information – Semi strong form
Information
set of
past prices –
Weak form
Conclusions on Informational Efficiency
 Market is generally regarded as being
weak-form informationally efficient.
 Market is generally regarded as being
semi-strong-form informationally
efficient.
 Market is generally regarded as NOT
being strong-form informationally
efficient.
Abnormal Returns in an
Informationally Efficient Market
 Do abnormal returns exist?
 Yes, due to price changes caused by new
info.
 Is this evidence against market
efficiency?
 No, because abnormal returns were not
expected.
 Remember, informational efficiency
deals with EXPECTED returns.
Implications for Investors
 Stock prices have no memory - only the
current price matters - it contains all info
about past prices.
 Trust market prices - they reflect all info (at
least all public info)
 Don’t trust your broker, on average they will
only be right due to luck!
 A buy and hold strategy is optimal because you can’t expect to get in and out
of securities in a way that will boost your
return – unless you have inside info.
Implications for Managers



If markets react negatively to a managerial decision, the
decision may truly be bad
Managers shouldn’t try to fool the market. Eventually they
will be found out and then lose their credibility for the
future. Often the market is able to see through the
manipulations (such as accounting practices or
changes)quickly; sometimes it takes time (Enron,
Worldcom) but the end result is not good.
The only time not to trust market prices is when you have
better info, not public info. For managers this info may be
info related to their own firm. It is not likely that managers
have better information on macroeconomic variables like
inflation, interest rates, unemployment, exchange rates,
etc.
 Look out for violating insider trading laws if you are trading
based on “better” information.
What about wild market fluctuations?
 You can get wild fluctuations with market efficiency.
 If the public generally believes certain info means
something good, they will bid up the prices of stocks.
 But if they change their minds, stock prices will fall.
 Sometimes the public becomes more confident as
more good reports are generated thus bidding up
stock prices to very high levels. When a bad report
finally comes out, their bubble of over-confidence can
burst – then prices plunge. This may be a partial
explanation for market crashes. The problem is that it
is often difficult to identify the crash-causing info.
Wild Market Fluctuations and
Informational Efficiency
 Is this evidence against market efficiency?
 Maybe … if people could predict the crash.
 If you follow analysts, though, you will see that at any one
time there are some predicting a bear market (dropping
prices) while others are predicting a bull market (prices
rising).
 It is usually only after-the-fact that those who correctly
predicted exclaim “The market is definitely not efficient
because I predicted the crash!”
 The question that you should ask is whether they
 were just lucky in their predictions or
 can consistently predict what will happen in the future.
 Most evidence says the latter explanation is wrong!
Summary and Conclusions
 With operational efficiency and informational efficiency, the
conditions are right for the optimal allocation of resources in the
economy (allocational efficiency).
 The three forms of informational efficiency (weak, semi-strong,
strong) correspond to how much information is reflected in
security prices. Most developed markets are generally considered
semi-strong form informationally efficient (so past price info and
other public info is generally assumed to be reflected in security
prices). Insider trading profits are evidence markets are not
strong form efficient. In addition, there are various anomalies
that contradict weak and semi-strong form efficiency.
 New information is unpredictable and thus so are changes in
stock prices. (Random Walk Hypothesis)
 Given the degree of informational efficiency that does exist in our
financial markets, it is best to trust market prices (unless you
have legal info nobody else has) and not to try to fool the market.