CHAPTER 11
The Efficient Market Hypothesis
2
Topics
• Definition of Market Efficiency
– Random walk process
– Rapid price adjustment
– Incapable of beating the market
• Three forms of market efficiency
– Weak-from
• Technical analysis
– Semi-strong form
• Event studies and Anomalies
– Strong-form
• Insider trading
• Active versus passive management
• Mutual fund performance
3
Market Efficiency Means…
• If the market is efficient, changes in stock price follows
random walk process - the theory that changes in
security prices occur randomly.
• So, there is no way to know where prices are headed.
• Prices are as likely to go up as to go down on any
particular day.
• When there is no discernable pattern to the path that a
stock price follows, then the stock’s price behavior is
largely consistent with the notion of a random walk.
• Maurice Kendall (1953) found no predictable pattern in
stock prices.
4
Random Walks and Stock Prices
5
Market Efficiency Means…
• What makes changes in stocks prices follow random
walk process then?
– New information (earning surprises, M&As, and
upgrades/downgrades) arrives in the market
unpredictably.
– Information is widely available to all investors and is
free/easy to obtain.
– Stock prices that change in response to new
(unpredictable) information also must move unpredictably.
– Therefore, stock price changes follow a random walk.
• This means that a historical pattern of stock prices is
not a good indicator for the future performance.
– “Today's price is no good for forecasting tomorrow's price.”
6
Market Efficiency Means…
• If the market is efficient, stock prices respond quickly
to changes (or new information) in the current
situation.
•
This may occur because a large number of competing profitmaximizing investors analyze and value securities, each
independently of the others, and adjust security prices rapidly to
reflect the effect of new information.
•
Information is widely available to all investors and is free/easy to
obtain.
•
As a result, investors react quickly and accurately to new
information, causing prices to adjust and current market price reflect
all available information about a security and the expected return
based upon this price is consistent with its risk.
•
Therefore, securities are normally in equilibrium and are “fairly
priced.”
Price Adjustments to New
Information
7
8
Cumulative Abnormal Returns Before
Takeover Attempts: Target Companies
9
Stock Price Reaction to CNBC Reports
10
Market Efficiency Means ….
• A basic question: Can you, as an investor, consistently
“beat the market?”
• It may surprise you to learn that evidence strongly
suggests that the answer to this question is “probably
not.”
• If the market is efficient, it is not possible to “beat the
market” (except by luck or insider information).
• We show that even professional money managers have
trouble beating the market.
11
“Beating the Market” means…
• Hard to beat the average market perofrmance on a riskadjusted basis consistently.
• Earning a higher return is not necessarily outperforming the
market. Considering risk is also important.
– For example, if your portfolio with a beta of 3 returned 20%, as
opposed to Vanguard 500 Index Fund with a beta of 1 yielded
15% for a given year, your portfolio did not necessary beat the
market.
• This is why we need to measure the excess return.
– The excess return on an investment is the return in excess of
that earned by other investments that have the same risk.
– “Beating the market” means consistently earning a positive
excess return.
12
The Driving Force Toward Market Efficiency:
Why Would a Market be Efficient?
• The driving force toward market efficiency is simply
competition and the profit motive that drive prices to reflect
information.
• Information-gathering is motivated by desire for higher
investment returns.
– Even a relatively small performance enhancement can be worth a
tremendous amount of money.
– 1% increase in performance of $1 billion fund = $10 million
– So, a portfolio manager is willing to spend up to $10 million for research
to improve 1% gain.
• This creates incentives to unearth relevant information and
use it.
Efficient Market Hypothesis
(EMH)
• The Efficient market hypothesis (EMH) is a theory that
asserts:
– The major financial markets reflect all relevant information at a
given time — the type and source of information with which it is
reflected in prices.
• Levels of the EMH
– Weak Form EMH
– Semi-strong Form EMH – most realistic
– Strong Form EMH
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14
Forms of Market Efficiency
15
Three Forms Of Market Efficiency
Weak Form
Financial asset (stock) prices incorporate all
historical information into current prices.
Past stock price changes cannot help you
predict future price changes.
Semi-strong
Form
Stock prices incorporate all publicly available
information (historical and current).
Information in an SEC filing is incorporated into
a stock price as soon as it is made public.
Stock prices incorporate all information,
private as well as public.
Strong Form
Prices react as soon as new information is
generated.
Weak form
17
Forms of Market Efficiency
(i.e., what information is used?)
• A Weak-form Efficient Market is one in which
past prices and volume figures are of no use in
predicting future stock price changes and
beating the market because current prices
reflect all historical information.
– If so, then technical analysis is of little use.
– If so, then one should simply use a buy-and-hold
strategy.
Evidence Supporting
Weakly Efficient Hypothesis
• Research shows that security prices tend to reflect all
historical information,
– Which is easy to obtain and cheap.
• However, there are technical analysts using graphs
and statistics.
– Technical analysis: Using a past price data and other nonfinancial data to
identify future trading opportunities, often using charts, so those analysts
are called “chartists.”
– Technicians focus on past security prices.
– Look for meaningful trends in historical security prices.
– Attempt to extract predictions from whatever patterns they find` such as
using a filter rule (in next slide).
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19
Technical Analysis: Filter Rules
•
An X% filter is a mechanical trading rule
– If a security’s price rises by at least X%, buy and hold until the price peaks
and falls by at least X%
– When price decreases from a peak level by X%, liquidate long position and
sell short
– Hold short position until price reaches a low point and then begins to rise
– If (when) the price rises above X%, cover the short position and go long
•
If stock prices fluctuate randomly, filter rules should not outperform
randomly chosen stocks.
•
In general, filter rules generate large commissions (especially those
with small X values)
– After deducting for commissions, filter rules do not outperform naïve buyand-hold strategy
– Some filters result in large net losses after deducting commissions
20
Using a 10% Filter Rule to Trade a
Security
21
Does Old Information Help Predict
Future Stock Prices?
• Researchers have used sophisticated techniques to test
whether past stock price movements help predict future
stock price movements.
– Some researchers have been able to show that future returns
are partly predictable by past returns. BUT: there is not enough
predictability to earn an excess return.
– Also, trading costs swamp attempts to build a profitable trading
system built on past returns.
– Result: buy-and-hold strategies involving broad market
indexes are extremely difficult to outperform.
– No matter how often a particular stock price path has related to
subsequent stock price changes in the past, there is no
assurance that this relationship will occur again in the
future.
22
Past Performance is No Guarantee of Future
Results!
23
Weak-Form Tests, I
• Returns over the short horizon
– Serial correlation: Tendency for stock returns to be
related to past returns.
– Some studies find a relatively weak but positive serial
correlation over short-term periods.
– Jegadeesh and Titman (1993) found a strong positive
correlation for particular market sectors or portfolios.
– This supports a momentum trading strategy;
• Momentum: Good or bad recent performance
continues over short to intermediate time horizons
24
Weak-Form Tests, II
• Returns over long horizons
– A multi-year study found a pronounced negative longterm serial correlation.
– Episodes of overshooting followed by correction:
• Stock market might overreact to relevant news .
• Such overreaction leads to positive serial correlation over
short-term horizon.
• Subsequent correction of the overreaction leads to poor
performance following good performance and vice versa.
Semi-strong form
26
Semistrong-form EMH
• A Semistrong-form Efficient Market is one in
which publicly available information is of no
use in beating the market because current
security prices reflect all public information.
– If so, then fundamental analysis is of little use, but
“inside” information may be illegally valuable.
– Any price anomalies are quickly found out and the
stock market adjusts accordingly.
27
Fundamental Analysis
• Fundamental Analysis - using economic
and accounting information to predict stock
prices
– Try to find firms that are better than everyone else’s
estimate.
– Try to find poorly run firms that are not as bad as the
market thinks.
– If the semi strong form efficiency is prevalent,
fundamental analysis is not useful in beating the
market.
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How New Information Gets into Stock
Prices
• Stock prices change when traders buy and sell shares
based on their view of the future prospects for the stock.
• But, the future prospects for the stock are influenced by
unexpected news announcements.
– Such as unexpected earnings increase, unexpected dividend
cuts, and unexpected lawsuits over company practices.
• Prices could adjust to unexpected news in three basic
ways:
– Efficient Market Reaction: The price instantaneously adjusts to
the new information.
– Delayed Reaction: The price partially adjusts to the new
information.
– Overreaction and Correction: The price over-adjusts to the
new information, but eventually falls to the appropriate price.
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Over-reaction, Efficient Reaction, and
Delayed Reaction
30
Event Studies, I.
• Researchers have examined the effects of many types of
news announcements on stock prices.
• To test for the effects of new information on stock prices,
researchers use an approach called an event study.
• Event studies that examine how fast stock prices adjust to
specific significant economic events.
• If the market is efficient, it would not be possible for investors to
experience superior risk-adjusted returns by investing after the
public announcement and paying normal transaction costs.
• Let us look at how researchers use this method. We will
use a dramatic example.
31
Event Studies, II.
•
On Friday, May 25, 2007, executives of Advanced Medical Optics, Inc.
(EYE), recalled a contact lens solution called Complete MoisturePlus Multi
Purpose Solution.
•
Advanced Medical Optics took this voluntary action after the Centers for
Disease Control and Prevention (CDC) found a link between the solution
and a rare cornea infection.
•
EYE Executives chose to recall their product even though no evidence was
found that their manufacturing process introduced the parasite that can lead
to cornea infection.
•
Further, company officials believed that the occurrences of cornea infection
were most likely the result of end users who failed to follow safe procedures
when installing contact lenses.
•
On Tuesday, May 29, 2007, EYE shares opened at $34.37, down $5.83
from the Friday closing price.
32
Event Studies, III.
33
Event Studies, IV.
• When researchers look for effects of news on stock
prices, they must make sure that overall market news is
accounted for in their analysis.
• To separate the overall market from the isolated news
concerning Advanced Medical Optics, Inc., researchers
would calculate abnormal returns.
• The abnormal return due to the event is the difference
between the stock’s actual return and a proxy for the
stock’s return in the absence of the event.
Abnormal return = Observed return – Expected return
Event Studies, V.
How Tests Are Structured
•
The expected return is calculated using a market index
(like the Nasdaq 100 or the S&P 500 Index) or by using a
long-term average return on the stock.
Market Model approach:
Excess (or Abnormal) Return = Observed - Expected
et = rt - (a + brMt)
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35
Event Studies, VI.
• Researchers are interested in:
• The adjustment process itself
• The size of the stock price reaction to a news announcement.
• Researchers then align the abnormal return on a stock to
the days relative to the news announcement.
– Researchers usually assign the value of zero to the news
announcement day.
– One day after the news announcement is assigned a value of
+1.
– Two days after the news announcement is assigned a value of
+2, and so on.
– Similarly, one day before the news announcement is assigned
the value of -1.
36
Event Studies, VII.
• According to the EMH, the abnormal return today should only relate
to information released on that day.
• To evaluate abnormal returns, researchers usually accumulate them
over a 60 or 80-day period.
• A plot of cumulative abnormal returns for Advanced Medical Optics,
Inc. beginning 40 days before the announcement.
– The first cumulative abnormal return, or CAR, is just equal to the
abnormal return on day -40.
– The CAR on day -39 is the sum of the first two abnormal returns.
– The CAR on day -38 is the sum of the first three, and so on.
– By examining CARs, researchers can see if there was over- or underreaction to an announcement.
37
Event Studies, VIII.
38
Event Studies, IX.
• As you can see, Advanced Medical Optics, Inc.’s cumulative
abnormal return hovered around zero before the announcement.
• After the news was released, there was a large, sharp downward
movement in the CAR.
• The overall pattern of cumulative abnormal returns is essentially
what the EMH would predict.
• That is:
– There is a band of cumulative abnormal returns
– A sharp break in cumulative abnormal returns, and
– Another band of cumulative abnormal returns.
39
Semistrong Tests: Anomalies
• We will now present some aspects of stock price
behavior that are both baffling and potentially hard to
reconcile with market efficiency.
– Researchers call these market anomalies.
• Critics of market efficiency points out these anomalies as
an evidence of market inefficiency.
• Anomalies:
–
–
–
–
–
Small Firm Effect (January Effect)
P/E Effect
Neglected Firm Effect and Liquidity Effects
Book-to-Market Ratios
Post-Earnings Announcement Price Drift
40
Anomalies
• The Size Effect: The small firms consistently
experienced significantly larger risk-adjusted returns
than large firms.
• The P/E Ratio Effect: Low P/E stocks experienced
superior risk-adjusted results relative to the market.
• The Book-to-Market Ratio Effect: A high B/M stocks
is positively correlated with future stock returns.
• Remember these information are publicly available. If
these anomalies are persistent, it is in conflict with the
EMH.
41
The Size Effect
Anomalies,
The Day-of-the-Week Effect
• The day-of-the-week effect refers to the tendency for
Monday to have a negative average return—which is
economically significant.
42
Anomalies,
The Amazing January Effect, I.
• The January effect refers to the tendency for small-cap stocks to
have large returns in January.
• Does the January effect exist for the S&P 500 or large stocks?
– It does not appear so.
43
Anomalies,
The Amazing January Effect, II.
• But, what do we see when we look at returns on small-cap stocks?
• Critics of market efficiency point to sizable gains to be had from
simply investing in January and ask:
– How can an efficient market have such unusual behavior?
– Why don’t investor take advantage of this opportunity and thereby drive it out of
existence?
44
Anomalies,
The Amazing January Effect, III.
• The January Effect is partially understood.
– Tax-loss selling: Sell losing stocks in December to realize
capital loss to offset capital gain earned from winning stocks to
reduce tax obligations, and buying back in January.
– “Window dressing”: Institutional investors have an incentive to
sell stocks that do poorly at the end of year to make their yearend performance look good.
45
46
The Book-to-Market Ratio Effect
47
Cumulative Abnormal Returns in
Response to Earnings Announcements
Past-Earnings-Announcement
Price Drift
• The abnormal return is positive for positive-surprise firms
and negative for negative-surprise firms.
• The cumulative abnormal returns of positive-surprise
stocks continue to rise-in other words, exhibit
momentum-even after the earnings information becomes
public.
• The sluggish price adjustment to earnings-surprises
appears to be a violation of market efficiency.
48
49
Interpreting the Anomalies
• The most puzzling anomalies are price-earnings,
small-firm, market-to-book, momentum, and longterm reversal.
– Fama and French argue that these effects can be explained by risk
premiums.
– F&F argues that these factors are simply proxies for risk.
– However, Lakonishok, Shleifer, and Vishney argue that these
effects are evidence of inefficient markets.
• Anomalies or data mining?
– Some anomalies have disappeared after publicly announced..
– Book-to-market, size, and momentum may be real anomalies.
– Value stock – defined by low P/E ratio, high-book-to market ratio, or
depressed prices relative to historic levels – seem to have provided
higher average returns than “glamour” or growth stocks.
50
Returns to Style Portfolio as a
Predictor of GDP Growth
Strong-form
52
Forms of Market Efficiency
(i.e., what information is used?)
• A Strong-form Efficient Market is one in which
information of any kind, public or private, is of no
use in beating the market because prices reflect
all public and private information.
– If so, then “inside information” is of little use.
– This assumes perfect markets in which all information
is cost-free and available to everyone at the same
time.
Who is an “Insider”?
More Comprehensive Definition
• For the purposes of defining illegal insider trading, an
insider is someone who has material non-public
information.
• Such information is both not known to the public and, if it
were known, would impact the stock price.
• A person can be charged with insider trading when he or
she acts on such information in an attempt to make a
profit.
53
Strong-Form Tests:
Inside Information
• If a market is strong-form efficient, no information of any kind,
public or private, is useful in beating the market.
• But, it is clear that significant inside information would enable
you to earn substantial excess returns.
• This fact generates an interesting question: Should any of us
be able to earn returns based on information that is not
known to the public?
• The ability of insiders to trade profitability in their own stock
has been documented in studies by Jaffe, Seyhun, Givoly,
and Palmon.
54
55
Insider Trading
• In the U.S. (and in many other countries) it is illegal to
make profits on non-public information.
– It is argued that this ban is necessary if investors are to have
trust in U.S. stock markets.
– The United States Securities and Exchange Commission (SEC)
enforces laws concerning illegal trading activities.
• It is important to be able to distinguish between:
– Informed trading
– Legal insider trading
– Illegal insider trading
56
Informed Trading
• When an investor makes a decision to buy or sell a stock
based on publicly available information and analysis,
this investor is said to be an informed trader.
• The information that an informed trader possesses might
come from:
–
–
–
–
Reading the Wall Street Journal
Reading quarterly reports issued by a company
Gathering financial information from the Internet
Talking to other investors
57
Legal Insider Trading
• Some informed traders are also insider traders.
• When you hear the term insider trading, you most likely think that
such activity is illegal.
• But, not all insider trading is illegal.
– Company insiders can make perfectly legal trades in the stock of their company.
– Corporate insiders include major corporate officers, directors, and owners of 10%
or more of any equity class of securities.
– They must comply with the reporting rules made by the SEC. For example,
insiders must report to the SEC each month on their transactions in the stock of
the firm for which they are insiders, and these insider trades are made public by
the SEC.
– In addition, corporate insiders must declare that trades that they made were
based on public information about the company, rather than “inside” information.
58
Illegal Insider Trading
•
When an illegal insider trade occurs, there is a tipper and a tippee.
•
It is difficult for the SEC to prove that a trader is truly a tippee.
•
It is difficult to keep track of insider information flows and subsequent
trades.
– The tipper is the person who has purposely divulged material non-public information.
– The tippee is the person who has knowingly used such information in an attempt to
profit.
– Suppose a person makes a trade based on the advice of a stockbroker.
– Even if the broker based this advice on material non-public information, the trader
might not have been aware of the broker’s knowledge.
– The SEC must prove that the trader was, in fact, aware that the broker’s information
was based on material non-public information.
•
Sometimes, people accused of insider trading claim that they just
“overheard” someone talking.
•
Be aware: When you take possession of material non-public
information, you become an insider, and are bound to obey insider
trading laws.
59
It’s Not a Good Thing: What did Martha do?
(Part 1)
•
The SEC believed that Ms. Stewart was told by her friend, Sam Waksal,
who founded a company called ImClone, that a cancer drug being
developed by ImClone had been rejected by the Food and Drug
Administration.
•
This development would be bad news for ImClone shares.
•
Martha Stewart sold her 3,928 shares in ImClone on December 27, 2001.
– On that day, ImClone traded below $60 per share, a level that Ms. Stewart
claimed triggered an existing stop-loss order.
– However, the SEC believed that Ms. Stewart illegally sold her shares because
she had information concerning FDA rejection before it became public.
•
The FDA rejection was announced after the market closed on Friday,
December 28, 2001.
•
This news was a huge blow to ImClone shares, which closed at about $46
per share on the following Monday (the first trading day after the information
became public).
60
It’s Not a Good Thing: What did Martha do?
(Part 2)
•
In June 2003, Ms. Stewart and her stock broker, Peter Bacanovic, were
indicted on nine federal counts. They both plead not guilty.
•
Ms. Stewart’s trial began in January 2004.
•
Just days before the jury began to deliberate, however, Judge Miriam
Cedarbaum dismissed the most serious charge of securities fraud.
•
Ms. Stewart, however, was convicted on all four counts of obstructing
justice.
– Judge Cedarbaum fined Ms. Stewart $30,000 and sentenced her to five months
in prison, two years of probation, and five months of home confinement.
– The fine was the maximum allowed under federal rules while the sentence was
the minimum the judge could impose.
– Peter Bacanovic, Ms. Stewart's broker, was fined $4,000 and was sentenced to
five months in prison and two years of probation.
So, to summarize:
Martha Stewart was accused, but not convicted, of insider trading.
Martha Stewart was accused, and convicted, of obstructing justice.
Mutual fund performance
62
Active or Passive Management
• Active Management
– An expensive strategy because of more frequent
rebalancing to pursue to beat the market.
– Suitable only for very large portfolios
• Passive Management
– Accept EMH, and therefore, passive portfolio
managers will NOT attempt to outsmart the
market.
– Buying index funds and ETFs is a sensible thing to
do.
– Very low costs because turnover or portfolio
rebalancing is low.
Mutual Fund Investment
Performance: A First Look
• Performance of actively managed funds:
– below the return on the Wilshire index in 23 of the 39
years from 1971 to 2009
– The average annual return on the index was 11.9%,
which was greater that that of the average mutual
fund.
– Evidence for persistent superior performance (due to
skill and not just good luck) is weak, but suggestive –
refer to the Malkiel studies.
– Bad performance more likely to persist
11-63
11-64
Diversified Equity Funds versus
Wilshire 5000 Index
11-65
Consistency of
Investment Results
66
Mutual Fund Performance: Cautions
• While looking at historical returns, the riskiness of the
various fund categories should also be considered.
• Whether historical performance is useful in predicting
future performance is a subject of ongoing debate.
• Some of the poorest-performing funds are those with
very high costs.
• Ratings by reputable research firm such as Morningstar
are as good indicator for the future performance as
anyone’s guess.
Mutual Fund Performance: The
Model to Evaluate
• The conventional performance benchmark
today is a four-factor model, which employs:
– the three Fama-French factors (the return on the
market index, and returns to portfolios based on size
and book-to-market ratio)
– plus a momentum factor (a portfolio constructed
based on prior-year stock return).
67
68
Estimates of Individual Mutual Fund
Alphas, 1993 - 2007
69
Mutual Fund Performance: The Hot
Hands Phenomenon
• Consistency, the “hot hands” phenomenon
– Carhart – weak evidence of persistency
– Bollen and Busse – support for performance
persistence over short time horizons
– Berk and Green – skilled managers will attract new
funds until the costs of managing those extra funds
drive alphas down to zero.
70
Risk-adjusted performance in ranking
quarter and following quarter
Mutual Fund Performance:
Summary
•
The evidence on the risk-adjusted performance of professional managers is
mixed at best.
•
The performance of professional managers as a group beat or are beaten by
the market fall within the margin of statistical uncertainty.
•
Performance superior to passive strategies is far from routine.
•
On the other hand, a small number of investment superstars–Peter Lynch,
Warren Buffett among then–have consistently beaten the market.
•
However, the records of the vast majority of professional money managers offer
convincing evidence that there are no easy strategies to guarantee success in
the securities markets.
•
There will be a smaller role for professional money managers than we
originally thought.
•
It makes little sense to time the market.
71
72
Market Efficiency and the Performance
of Professional Money Managers, I.
73
Market Efficiency and the Performance
of Professional Money Managers, II.
• Previous slides show the percentage of managed equity funds that
beat the Vanguard 500 Index Fund.
– In only 14 of the 30 years (1980—2009) did more than half beat the
Vanguard 500 Index Fund, when measured with one-year returns.
– The performance is worse when it comes to a 10-year investment
periods (1980-1989 through 2000-2009).
– When measured with ten-year returns, in only 3 of these 21 investment
periods, did more than half the professional money managers beat the
Vanguard 500 Index Fund.
• Conclusion
– In the previous table, the performance of professional money managers
is generally poor relative to the Vanguard 500 Index Fund. In
addition, the performance declines the longer the investment period.
74
Market Efficiency and the Performance
of Professional Money Managers, III.
•
The performance of professional money managers is especially
troublesome when we consider the enormous resources at their disposal
and the substantial survivorship bias that exists.
– Managers and funds that do especially poorly disappear.
– If it were possible to beat the market, then the process of elimination should lead
to a situation in which the survivors can beat the market.
– The fact that professional money managers seem to lack the ability to outperform
a broad market index is consistent with the notion that the equity market is
efficient.
•
The previous slides raise some potentially difficult and uncomfortable
questions for security analysts and other investment professionals.
– If markets are inefficient, and tools like fundamental analysis are valuable, why
can’t mutual fund managers beat a broad market index?
75
What is the Role for Portfolio
Managers in an Efficient Market?
• Even if the market is efficient a role exists for portfolio
management: to build a portfolio to the specific needs of
individual investors.
– Diversification: A basic principle of investing is to hold a well-diversified
portfolio.
– However, exactly which diversified portfolio is optimal varies by investor.
– Some factors that influence portfolio choice include the investor’s age, tax
bracket, risk aversion, and even employer. Employer?
• Suppose you work for Starbucks and part of your compensation is stock options.
• Like many companies, Starbucks offers its employees the opportunity to
purchase company stock at less than market value.
• You can imagine that you could wind up with a lot of Starbucks stock in your
portfolio, which means you are not holding a diversified portfolio.
• The role of your portfolio manager would be to help you add other assets to
your portfolio so that it is once again diversified.
So, are markets efficient?
77
Are Financial Markets Efficient?
• Financial markets are the most extensively documented
of all human endeavors.
• Colossal amounts of financial market data are collected
and reported every day.
• These data, particularly stock market data, have been
exhaustively analyzed to test market efficiency.
• But, market efficiency is difficult to test for various
reasons.
Are Financial Markets Efficient?
(Cont’d)
• Nevertheless, three generalities about market efficiency
can be made:
– Short-term stock price and market movements appear to be
difficult to predict with any accuracy.
– The market reacts quickly and sharply to new information, and
various studies find little or no evidence that such reactions can
be profitably exploited.
– If the stock market can be beaten, the way to do so is not
obvious.
78
Are Financial Markets Efficient?
(Cont’d)
• The performance of professional managers is broadly
consistent with market efficiency.
• Most managers do not do better than the passive
strategy.
• There are, however, some notable superstars:
– Peter Lynch, Warren Buffett, John Templeton, George Soros
79
Are Financial Markets Efficient?
(Cont’d)
• Magnitude Issue
– Only managers of large portfolios can earn enough
trading profits to make the exploitation of minor mispricing
worth the effort.
• Selection Bias Issue
– Only unsuccessful investment schemes are made public;
good schemes remain private.
• Lucky Event Issue
– There is always one or two investors (out of million
investors) who accomplishes a superior return in a given
year and get publicized more often than those
unsuccessful investors.
80
Other Issues, I.
Resource Allocation
• If markets were inefficient, resources
would be systematically misallocated.
– Firm with overvalued securities can raise
capital too cheaply.
– Firm with undervalued securities may have to
pass up profitable opportunities because cost
of capital is too high.
81
82
Other Issues, II.
Bubbles
• Bubbles and market efficiency
– Prices appear to differ from intrinsic
values.
– Rapid run up followed by crash
– Bubbles are difficult to predict and
exploit.
83
Other Issues, III.
Stock Market Analysts
• Some analysts may add value, but:
– Difficult to separate effects of new
information from changes in investor
demand
– Findings may lead to investing strategies
that are too expensive to exploit