Are Financial Markets
Efficient?
Overview of Presentation
• What is meant by “market efficiency?”
• Why is market efficiency important?
• Is the stock market “efficient?”
• What does market efficiency imply
about investing?
Disclaimer:
I am not trying to sell you anything
Disclaimer:
I am not trying to sell you anything
Disclaimer:
I am not trying to sell you anything
In 1990s, Dow went berserk!
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Dow Jones Industrial Index
Monthly Close, May 1949 - April 1999
Don’t be amazed; we have been down
this road before...
• Dutch Tulip Bubble--17th century
• South Sea Bubble -- 18th century
• Florida Land Bubble -- 1920s
• Great Bull Market of the 1920s
Famous Last Words...
“Stock prices have reached what
looks like a permanently high
plateau.”
Professor Irving Fisher
Yale University
Early Autumn, 1929
What is an Efficient Market?
“A market is efficient with respect to
information set t if it is impossible to make
economic profits by trading on the basis of
information set t .”
Michael C. Jensen
“Some Anomalous Evidence Regarding Market
Efficiency.”
Journal of Financial Economics 6 (1978): 95-101.
Huh????
Translation:
– after accounting for transactions and
information costs, you can’t beat the
market on a risk-adjusted basis.
Some markets are amazingly
efficient...
• Returns on orange juice futures
predicted the subsequent errors in
temperature forecasts issued by the
National Weather Service for the
central Florida region where most juice
oranges are grown.
Richard Roll
“Orange Juice and Weather.”
American Economic Review 74 (1984): 861-880.
Until recently, evidence strongly
supported market efficiency…
• Stock returns were unpredictable.
• Stock prices rapidly reacted to
new information (Event Studies).
• Actively managed mutual funds
turned in dismal records.
Poor Record of Mutual Funds: An
Example
Suppose that at the start of 1969, you had invested $10,000 in
an actively managed mutual fund and a Standard & Poor’s 500
Stock Index Fund. How much would these investments be
worth thirty years later?
$311,000
Source:
Burton G. Malkiel
A Random Walk down Wall Street
$171,950
Mutual Funds
S & P Index Fund
But, then troubling new
evidence began to emerge...
Pricing Anomalies
 January Effect: January is great for
stocks, especially small firm stocks.
 Weekend Effect: Weekends are bad
for stocks.
 Mean Reversion: Today’s winners
tend to be tomorrow’s losers and viceversa.
More Troubling Evidence:
• Crash of October 19, 1987: Large
correction with no apparent trigger.
• Track record of “Superior
Analysts:” Warren Buffett and Peter
Lynch
Perhaps, the most troubling
puzzle:
• Market efficiency implies brokers add
no economic value. Yet, over the
past 30+ years the number of brokers
in the U.S has more than tripled.
This new evidence has led
to the rise of a new school
of thought in academia...
• Behavioralists
Behavioralists believe:
(1) Some investors are not fully rational and
their demand for risky assets is affected
by beliefs or sentiments not fully justified
by fundamental news. (Noise Traders)
(2)Arbitrage—defined as trading by fully
rational investors not subject to such
sentiment—is risky and therefore limited.
Behavioralists conclude:
• Assumptions (1) and (2) taken together
imply changes in investor sentiment are
not fully countered by arbitrageurs (and
hence affect security returns).
Andrei Shleifer and Lawrence H. Summers
“The Noise Trader Approach to Finance.”
Journal of Economic Perspectives 4, no. 2 (1990): 19-33.
Implication of
Behavioralism:
• You can make money exploiting
predictable patterns in securities prices.
But wait…
New evidence may not be fatal to
efficient markets hypothesis:
• “Bad Model” Problem: tests of market
efficiency are really joint tests of an asset
pricing model and market efficiency.
“Anomalies” such as calendar effects or
mean reversion may be due to bad asset
pricing models.
New evidence may not be fatal:
• Data Mining: If you let computers churn
long enough, you will find an anomaly.
Journals publish anomalies, not
confirmations of market efficiency.
The new evidence may not be fatal:
Market Crashes: Can be explained with a
rational investor model...
 Small changes in interest rates and risk perceptions
can induce large changes in share prices.
 Cumulative impact of a series of small events can
induce changes in risk perceptions (“straw that
broke the camel’s back”)
The new evidence may not be fatal:
Superior Analysts:
 Warren Buffett takes an active role on boards of the
companies he invests in. His spectacular success may
have more to do with his directorial ability than his
aptitude for picking stocks.
 Peter Lynch: You cannot rule out the possibility that
Lynch was just lucky. His true brilliance lies in
recognizing that his luck would not hold out. Thus, he
retired early.
The new evidence may not be fatal:
• Superior Analysts:
– Man tends to see causality in random
patterns in the data, thereby attributing
abnormal returns to skill rather than to luck.
The new evidence may not be fatal:
Superior Analysts:
 Example: Assume you are holding a stock
worth $50. Now, further assume its value
in each successive period is determined by
the flip of a fair coin. Whenever coin shows
“heads,” stock gains $1. Whenever coin
shows “tails,” the stock loses $1. Let’s flip
a coin repeatedly and track stock price.
How do you explain the brokers
puzzle?
• “There’s a sucker born every minute”
P.T. Barnum
• Brokers add value by selling
financial planning, not by picking
stocks
What’s the point of all this?
• To overthrow efficient markets paradigm,
you need:
– damning evidence.
– a better model.
Behavioralists have neither!
Lessons from the Real World
“I have personally tried to invest money, my
client’s money and my own, in every single
anomaly and predictive advice that
academics have dreamed up…I have
attempted to exploit the so-called year-end
anomalies and a whole variety of strategies
supposedly documented by academic
research. And I have yet to make a
nickel on any of these supposed market
inefficiencies.”
Richard Roll
Professor of Finance
UCLA
Bottom Line:
The stock market is
efficient. There is no way to
get rich quick.
Efficient Market Lessons
for Investing
Only two ways to post consistently
high returns:
– Take more risk
– commit fraud
Remember:
Brother Ty’s Seventh Law of
Spiritual and Financial Growth
• “The only way to get rich from a
get-rich book is to write one.”
Source: Christopher Buckley and John Tierney
God is My Broker
Efficient Market Lessons
for Investing
Invest in an stock index fund and hold:
– don’t pick stocks
– don’t try to time market
October. This is one of the peculiarly dangerous months to
speculate in stocks. The others are July, January,
September, April, November, May, March, June, December,
August, and February
Mark Twain
Pudd’nhead Wilson
Efficient Market Lessons
for Investing
• How much of your wealth
should you hold in stocks?
– A lot… even more if you are
young
How to use a broker:
• Use him as a financial planner.
• Let him educate you about riskreturn trade-offs.
• Don’t let him pick stocks for you.
Beware:
A Fool and His Money are Soon Parted...
Beware:
A Fool and His Money are Soon Parted...
Beware:
A Fool and His Money are Soon Parted...
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