Efficient Market Hypothesis vs. Behavioral Finance
 Market Efficiency
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Random walk versus market efficiency
Versions of market efficiency
Technical analysis vs. fundamental analysis
Predictors of future returns and market anomalies
Behavioral finance
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Cumulative Abnormal Returns Around Takeover
Attempts: Target Companies
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Stock Price Reaction to CNBC Reports
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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.
 What does competition mean here? -- page 351
 Is there a role for active portfolio management in
an efficient market?
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Forms of the EMH
 Weak
 Semi-strong
 Strong
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See page 347-348.
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Types of Stock Analysis
 Technical Analysis - using prices and volume information
to predict future prices.
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Weak form efficiency & technical analysis
Chartist
Relative strength versus resistance levels
 Fundamental Analysis - using economic and accounting
information to predict stock prices.
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Semi strong form efficiency & fundamental analysis
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Technical Analysis
 Relative strength – page 348
 Resistance levels – upper bound or
 Support levels – lower bound
 Whether a workable technical trading rule will
continue to work in the future once it becomes
publicly known?
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Fundamental Analysis
 Uses earnings and dividend prospects of the firm,
expectations of future interest rates, and risk
evaluation of the firm to determine proper stock
prices.
 Fundamental analysis is much beyond identifying
well-run firms with good prospects. It is to
identify companies better than every else’s
estimate.
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Active or Passive Management
 Active Management
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Security analysis
Timing
 Passive Management
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Buy and Hold
Index Funds
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Market Efficiency & Portfolio
Management
Even if the market is efficient a role exists for
portfolio management:
 Appropriate risk level
 Tax considerations
 Other considerations
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Empirical Tests of Market Efficiency
 Event studies
 Assessing performance of professional managers
 Testing some trading rule
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Issues in Examining the Results
 Magnitude Issue
 Selection Bias Issue: investing in small stocks
 Lucky Event Issue
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Weak-Form Tests
 Serial Correlation
 Momentum
 Returns over Long Horizons
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Experience with 911
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Anticipating market chaos, panic selling and a disastrous loss of value in the wake of the
attacks, the NYSE and the Nasdaq remained closed until September 17, the longest
shutdown since 1933. Moreover, many trading, brokerage and other financial firms had
offices in the World Trade Center and were unable to function in the wake of the tragic
loss of life and collapse of both towers.
On the first day of NYSE trading after 9/11, the market fell 684 points, a 7.1% decline,
setting a record for the biggest loss in exchange history for one trading day. At the close
of trading that Friday, ending a week that saw the biggest losses in NYSE history, the
Dow Jones was down almost 1,370 points, representing a loss of over 14%.
Major stock sell-offs hit the airline and insurance sectors as anticipated when trading
resumed. Hardest hit were American Airlines and United Airlines, carriers whose planes
were hijacked for the terrorist attacks.
American Airlines (NYSE:AMR) stock dropped from a $29.70 per share close of
September 11 to $18.00 per share close on September 17, a 39% decline. United
Airlines (NYSE:UAL) stock dropped from $30.82 per share close to $17.50 per share
on the close on September 17, a 42% decline.
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Also: Program trading; algorithmic trading; and high-frequency trading:
According to the New York Stock Exchange, in 2006 program trading accounts for
about 30% and as high as 46.4% of the trading volume on that exchange every day.
http://www.programtrading.com/
The greatest point loss of the Dow Jones Industrial Average was 777.68 points on
September 29, 2008.
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Predictors of Broad Market Returns
 Fama and French
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Aggregate returns are higher with higher dividend
ratios
 Campbell and Shiller
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Earnings yield can predict market returns
 Keim and Stambaugh
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Bond spreads can predict market returns
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Anomalies
 P/E Effect
 Small Firm Effect (January Effect)
 Neglected Firm
 Book-to-Market Effects
 Post-Earnings Announcement Drift
http://biz.yahoo.com/research/earncal/today.html
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Returns in Excess of Risk-Free Rate and in excess of the
Security Market Line for 10 Size-Based Portfolios, 1926 –
2005
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Average Monthly Returns as a Function of the BookTo Market Ratio, 1963 – 2004
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Cumulative Abnormal Returns in Response to
Earnings Announcements
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Mutual Fund Performance
 Some evidence of persistent positive and negative
performance.
 Potential measurement error for benchmark
returns.
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Style changes
May be risk premiums
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Persistence of Mutual Fund Performance
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Behavioral Finance
 The premise of behavioral finance is that
conventional financial theory ignores how real
people make decisions and that people make a
difference.
 Investors Do Not Always Process Information
Correctly
 Investors Often Make Inconsistent or
Systematically Suboptimal Decisions
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Behavioral Biases
 Framing
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Decisions seem to be affected by how choices are framed – page
387
example
 Mental Accounting
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A special form of framing in which people segregate certain
decisions
example
 Regret Avoidance
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Individuals would have more regrets when their decisions are more
unconventional
example
 Prospect Theory
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Traders become risk seeking after they lose money
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Prospect Theory Graphs
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Prospect theory (2)
 Loss aversion: utility depends not on the level of
wealth from current levels.
 The convex curvature to the left of the origin will
induce investors to be risk seeking rather risk
averse when it comes to losses
 Traders in T-bond futures often take significantly
greater risk in afternoon sessions following
morning sessions in which they have lost money
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Limits to Arbitrage
 Fundamental Risk
 Implementation Costs
 Model Risk
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Limits to Arbitrage and the Law of One Price
 Violations
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Siamese Twin Companies
Equity Carve-outs
Closed-End Funds
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Bubbles and Market Efficiency
 The bust of dot-com bubble
 Financial crisis – housing price bubble
 Hard to be justified by the position that security
prices represent rational, unbiased assessments of
intrinsic value.
 Dynamic risk taking – excessive risk taking in
bubble period
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Technical Analysis and Behavioral Finance
 Trends and corrections
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momentum (page 393)
Dow theory: primary trend, secondary trend, and
tertiary trend
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see Figure 12-4
Moving averages
Breadth: the spread between the number of stocks
that advance and decline in price.
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Technical Analysis and Behavioral Finance
 Trin statistic
 Confidence index
 Put/call ratio
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Investment-based CAPM
 Cochrane (1991, 1996)
 Low costs of capital imply high NPV of new
projects and high investment
 High costs of capital imply low NPV of new
project and low investment
 Inverse relationship between expected return and
investments
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