Vicentiu Covrig
The Efficient Capital Markets
(chapter 12 Jones)
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Efficient Markets
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How well do markets respond to new information?
Should it be possible to decide between a profitable and
unprofitable investment given current information?
Efficient Markets
◦ The prices of all securities quickly and fully reflect all available
information
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Conditions for an Efficient Market

Large number of rational, profit-maximizing investors
◦ Actively participate in the market
◦ Individuals cannot affect market prices
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Information is costless, widely available, generated in a
random fashion
Investors react quickly and fully to new information
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Consequences of Efficient Market
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Quick price adjustment in response to the arrival of
random information makes the reward for analysis low
Prices reflect all available information
Price changes are independent of one another and move
in a random fashion
◦ New information is independent of past
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Alternative Efficient Market Hypotheses
The various forms of the efficient market hypothesis differ in terms
of the information that security prices should reflect.
 Weak-form EMH
 Semistrong-form EMH
 Strong-form EMH
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Weak-Form EMH
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Current prices fully reflect all security-market information, including the
historical sequence of prices, rates of return, trading volume data, and other
market-generated information
This implies that past rates of return and other market data should have no
relationship with future rates of return
Implication:

Examining recent trends in price and other market data (called Technical analysis)
in order to predict future price changes would be a waste of time if the market is
weak-form efficient
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Tests and Results: Weak-Form EMH
Problems with tests
 Cannot be definitive since trading rules can be complex and there
are too many to test them all
 Testing constraints
- Use only publicly available data
- Should include all transactions costs
- Should adjust the results for risk (an apparently successful
strategy may just be a very risky strategy)
If someone writes a book on how to “beat the market,” you can bet that book
sales are more lucrative than the trading strategy!
Even if it once worked, if it’s widely known, it won’t work any more!
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Semistrong-Form EMH
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Current security prices reflect all public information, including market and nonmarket information
This implies that decisions made on new information after it is public should
not lead to above-average risk-adjusted profits from those transactions
Implication:

If the market is efficient in this sense, information in The Wall Street Journal,
other periodicals, and even company annual reports is already fully reflected
in prices, and therefore not useful for predicting future price changes.
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Strong-Form EMH

Stock prices fully reflect all information from public and private
sources
Implication:
Not even “insiders” would be able to “beat the market” on a
consistent basis
Evidence does not support strong form EMH.
Insiders can make a profit on their knowledge, and people go to
jail, get fined, or get suspended from trading for doing so.
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Anomalies
The low PE effect : Some evidence indicates that low PE
outperform higher PE stocks of similar risk.
stocks
Low-priced stocks : Many people believe that
the price of every stock has an optimum trading range.
The small firm effect : Small firms seem to provide superior
risk-adjusted returns.
The neglected firm effect : Neglected firms seem to offer superior
returns with surprising regularity
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Anomalies
Market Overreaction and Momentum : It is observed that the market tends to
overreact to extreme news. So, systematic price reversals can sometimes be
predicted.
Security Analysts
 This looks at whether, after a stock selection by an analyst is made known, a
significant abnormal return is available to those who follow their
recommendation
 There is some evidence of superior analysts, and as a group the stocks with
better analysts ratings have better returns
 The Value Line Enigma
- Advisory service that ranks 1700 stocks from best (1) to worst (5)
Probable price performance in next 12 months
- 1980-1993, Group 1 stocks had annualized return of 19.3%
Best investment letter performance overall
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Other Tests and Results
Professional Money Managers
 If any investor can achieve above-average returns, it should be this
group
 If any non-insider can obtain inside information, it would be this
group due to the extensive management interviews that they conduct
 Risk-adjusted returns of mutual funds generally show that most
funds did not match aggregate market performance
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The Rationale and Use of Index Funds
(passive investing)
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Efficient capital markets and a lack of superior analysts imply that
many portfolios should be managed passively (so their performance
matches the aggregate market, minimizes the costs of research and
trading)
Institutions created market (index) funds which duplicate the
composition and performance of a selected index series
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Behavioral Finance
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Behavioral Finance vs Standard Finance
Behavioral finance considers how various psychological traits
affect investors
Behavioral finance recognizes that the standard finance model of
rational behavior can be true within specific boundaries but argues
that this model is incomplete since it does not consider the individual
behavior.
Currently there is no unified theory of behavioral finance, thus the
emphasis has been on identifying investment anomalies that can be
explained by various psychological traits.
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Loss Aversion and Mental Accounting
First decision: Choose between
Choice 1: sure gain of $ 85,000
Choice 2: 85% chance of receiving $100,000 and 15%
chance of receiving nothing
Second decision: Choose between
Choice 1: sure loss of $ 85,000
Choice 2: 85% chance of losing $100,000 and 15%
chance of losing nothing
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Mental Accounting
Individuals tend to keep a mental account for each investment option,
instead of looking at the investment decisions as a “package”
Many investors are highly risk averse with money in some
accounts and risk lovers with money in other accounts
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Mental Accounting: sunk costs
You have a ticket to a Dodgers game, ticket worth $60. On the day
of the game there is a big rain. Although you can still go to the
game and the game is playing, the rain will reduce the pleasure
of watching the game. Are you more likely to go to the game if
you purchased the ticket or if the ticket was given to you for
free?
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Seeking pride and avoiding regret
Rational individuals feel no greater disappointment when they
miss their plane by a minute as when they miss it by an hour.
What about most of us?
Most of the investors sell winners too early, riding losers too
long (called the disposition effect)
Individuals who make decisions that turn out badly have more regret
when that decisions were more unconventional
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