Laurence Booth
Sean Cleary
10
Market Efficiency
LEARNING OBJECTIVES
Explain the importance of the concept of market efficiency.
Explain what is meant by “market efficiency.”
Differentiate among the different levels of efficiency.
Discuss the general consensus based on empirical evidence of
market efficiency, as well as the existence of some well-known
anomalies.
10.5 Differentiate between behavioural finance and the traditional view
of finance.
10.6 Explain the implications of market efficiency.
10.1
10.2
10.3
10.4
10.1 THE IMPORTANCE OF MARKET
EFFICIENCY
• Understanding security valuation provides guidelines to managers
about how they should manage businesses on behalf of
shareholders
• The discount rate that represents shareholders’ required rate of
return is established as a result of benchmark rates in the capital
markets such as the risk-free rate and the market risk premium
• If market prices reflect the actions of managers, then managers
must learn what actions they should take in order to fulfill their
legal and managerial responsibilities to shareholders
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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10.1 THE IMPORTANCE OF MARKET
EFFICIENCY
• There are three elements of market efficiency:
– Operational efficiency: transaction costs are low, thereby
enhancing trading of securities
– Allocational efficiency: there are enough securities to
efficiently allocate risk
– Informational efficiency: market prices fairly and quickly
reflect all available information about the firm and managers’
actions
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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10.2 THE IMPORTANCE OF MARKET
EFFICIENCY
• The closer the link between managers’ actions and the value of the
firm, the more informationally efficient the capital market
• Securities laws in Canada reflect the belief that there is, or should be, a
strong connection between information and stock prices and these laws
reflect a number of common principles related to parties, transactions
and access to information, such as:
– Continuous disclosure of all material information about the firm.
– Fair and equal treatment of all market participants through
disclosure requirements that ensure all participants have
simultaneous access to the same information about publicly traded
firms. This avoids information asymmetries (i.e., when one party to
a transaction has access to a more complete and accurate set of
facts than the other party; that party has an advantage over other
parties to the transaction)
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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10.2 THE IMPORTANCE OF MARKET EFFICIENCY
• An efficient market is a market that reacts quickly and relatively
accurately to new public information, which results in prices that are
correct on average.
• For markets to operate efficiently, four conditions must exist:
1. A large number of rational, profit-maximizing investors exist, who
actively participate in the market by analyzing, valuing and trading
securities. The markets must be competitive, meaning no one
investor can significantly affect the price of the security through
their own buying and selling.
2. Information is costless and widely available to market participants
at the same time.
3. Information arrives randomly and therefore announcements over
time are not serially connected.
4. Investors react quickly and fully (and reasonably accurately) to the
new information, which is reflected in stock prices.
Booth • Cleary – 3rd Edition
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10.3 THE EFFICIENT MARKET HYPOTHESIS
(EMH)
• The efficient market hypothesis (EMH) is the theory that
markets are efficient and therefore, in its strictest sense,
implies that prices accurately reflect all available information
at any given time.
• There are three forms of the EMH:
– Weak Form EMH
– Semi-strong Form EMH
– Strong Form EMH
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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10.3 THE EFFICIENT MARKET HYPOTHESIS
(EMH)
• Weak Form EMH is the theory that security prices reflect
all market data, referring to all past price and volume
trading information.
• Implication: Markets that are weak-form efficient will
have all historical trading data reflected or discounted in
current prices and these should be of no value in
predicting future prices changes.
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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10.3 THE EFFICIENT MARKET HYPOTHESIS
(EMH)
• Semi-strong Form EMH is the theory that all publicly known
and available information is reflected in security prices. It
assumes the weak-form set of information is incorporated as
well as all public information pertinent to the security such
as: earnings, dividends, corporate investments and
management changes.
• Implication: Markets that are semi-strong-form efficient will
have all publicly available information reflected or
discounted in current prices and so it is futile to analyze
public information in an attempt to identify mispriced
securities.
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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10.3 THE EFFICIENT MARKET HYPOTHESIS
(EMH)
• Strong Form EMH is the theory that all public and private
information is reflected in security prices.
• Implication: Markets that are strong-form efficient always
have securities that are fairly priced. Therefore, neither
publicly available information nor insider information can be
used to identify mispriced securities.
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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10.4 EMPIRICAL EVIDENCE REGARDING
MARKET EFFICIENCY
• All scientific tests of the efficient market hypothesis attempt to
demonstrate that using a particular source of information allows
an investor to consistently earn abnormal returns.
• Abnormal returns are percentage returns that are greater than
the returns from a naïve buy-and-hold strategy where an investor
passively buys a market index portfolio such as the S&P/TSX 60
Composite Index.
• These studies attempt to identify active investment strategies
based on trading rules and sources of information that generate
greater risk-adjusted returns than a passive, naïve investment
strategy. If such strategies exist, then, depending on the nature of
the strategy, forms of the EMH can be declared invalid.
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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10.4 EMPIRICAL EVIDENCE REGARDING
MARKET EFFICIENCY
Weak Form Evidence
• Anomalies are exceptions to a rule or theory. Note: an anomaly
may not violate a theory if it cannot be consistently and profitably
exploited after accounting for transaction costs and taxes
• The random walk hypothesis states that security prices follow a
random walk with price changes over time being independent
from one period to the next. This hypothesis is logical if
information arrives randomly, as it should, and if investors react
quickly to it.
• Tests of weak form efficiency include:
– Serial correlation tests
– Runs (or signs) tests
– Testing of trading rules used by technical analysts
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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10.4 EMPIRICAL EVIDENCE REGARDING
Weak Form Evidence MARKET EFFICIENCY
Several anomalies contest
weak form market
efficiency:
1. Investors overreact to
new information and
this leads stock prices
to over-shoot and
under-shoot intrinsic
value. Therefore, stock
price reversals can, in
some cases, favour
contrarian trading
strategies.
2. Momentum has been detected in stock returns (see Figure 10.1)
3. Seasonal patters have been detected in stock returns, including the January
effect, day-of-the-week effect, and day-of-the-month effect
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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10.4 EMPIRICAL EVIDENCE REGARDING
MARKET EFFICIENCY
Weak Form Evidence
• The anomalies identified by studies of financial markets
are very difficult and risky to exploit because:
– Transaction costs reduce or even eliminate the
economic advantage
– The anomalies occur too inconsistently to be a reliable
source of abnormal returns
• Weak Form EMH Conclusion: Capital markets appear to
be weak-form efficient.
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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10.4 EMPIRICAL EVIDENCE REGARDING
MARKET EFFICIENCY
Semi-Strong Form Evidence
• Tests of semi-strong form efficiency include:
– Event studies on the impact of earnings surprises and
corporate announcements on stock prices
– Studies that test whether investors can use publicly
available information to consistently generate abnormal
returns over the long-term
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
15
10.4 EMPIRICAL EVIDENCE REGARDING
MARKET EFFICIENCY
Semi-Strong Form Evidence
Event Studies
• Examine stock returns to determine the impact of a particular
event on stock prices before, during and following the event
• Events include:
– Company-specific announcements, such as stock splits,
dividend changes, accounting policy changes and takeovers
– Economic changes, such as unexpected interest rate
changes
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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10.4 EMPIRICAL EVIDENCE REGARDING
MARKET EFFICIENCY
Semi-Strong Form Evidence
Event Studies
Figure 10-2 illustrates the price
adjustment process for:
a.an efficient market
b.overreaction in an inefficient
market
c.slow reaction in an efficient
market
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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10.4 EMPIRICAL EVIDENCE REGARDING
MARKET EFFICIENCY
Event Studies
• Most event studies
have shown that stock
prices change before
an announcement, as
demonstrated in Figure
10-3
• Therefore, an investor
cannot usually move
quickly enough when
an announcement is made to profit from the new information
• This supports semi-strong form EMH, but this does not support the
strong form EMH because some investors are able to profit from private
information that will cause price changes when announcements occur
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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10.4 EMPIRICAL EVIDENCE REGARDING
MARKET EFFICIENCY
Earnings Surprises
• Several studies have identified a lag when earnings either exceed or fall short
of consensus earnings estimates
• Positive earnings surprises cause stock prices to go up
• Negative earnings surprises cause stock prices to drop
• These substantial adjustments after the announcement date contract the
semi-strong form of the EMH
Semi-Strong Anomaly Tests
• The strongest evidence of semi-strong market efficiency is the fact that
professional fund managers with all their training, expertise, technological
capability and access to date generally and on average do not consistently
outperform the market on a risk-adjusted basis.
• After expenses, the average professional fund manager performs worse than
their performance benchmarks over the long-term
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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10.4 EMPIRICAL EVIDENCE REGARDING
MARKET EFFICIENCY
Investment Styles
• Value investment styles consistently outperform growth
investing
• Value stocks have below-average price-earnings (P/E) ratios
and market-to-book (M/B) ratios, and above-average dividend
yields
• Growth stocks are those that have above-average P/E and M/B
ratios and below-average dividend yields, because investors
are prepared to pay a premium for expected future growth in
earnings and share price
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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10.4 EMPIRICAL EVIDENCE REGARDING
MARKET EFFICIENCY
Size Effect
• Small capitalization stocks outperform the broad market,
although their returns were much more volatile
• These findings contradict the semi-strong form of the
EMH, but transaction costs make it difficult to profit
from this anomaly
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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10.4 EMPIRICAL EVIDENCE REGARDING
MARKET EFFICIENCY
The Value Line Investment Survey Effect
• The Value Line Investment Survey is a widely followed stock
analysis publication that ranks stocks from best (1) to worst (5)
• Substantial empirical evidence suggests that stocks ranked 1 or 2
experience superior performance over the following 12 months,
while those that are assigned to lower-ranked categories perform
poorly
• These findings contradict the semi-strong form of the EMH
• However, transaction costs make it difficult to profit from this
anomaly
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
22
10.4 EMPIRICAL EVIDENCE REGARDING
MARKET EFFICIENCY
Semi-strong Form EMH Conclusion: Most studies support the
semi-strong form of the EMH, although a number of
anomalies have been identified.
Summary of Semi-Strong Form Anomalies:
• Value investing has consistently outperformed growth investing
• The size effect shows that small market capitalization (small cap)
stocks tend to outperform large capitalization stocks on a riskadjusted returns basis
• The Value Line Investment Survey effect
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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10.4 EMPIRICAL EVIDENCE REGARDING
MARKET EFFICIENCY
Strong Form Evidence
Evidence on Strong Form Efficiency
• If a market is strong-form efficient, then not even insiders could profit from
using information about the company that is unknown to the investing public,
since prices reflect all public and private information
• Tests of strong form efficiency focus on determining whether any group of
investors has information that allows them to earn abnormal profits
consistently
– Several studies have found consistent abnormal profits, while others found
only slightly better than average returns
Strong Form EMH Conclusion: On balance, evidence does not support the strong
form of the EMH. Insider trading laws restrict the ability of investors to act on
their inside information. These laws may explain the lack of strong evidence
for this form of the EMH.
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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10.4 EMPIRICAL EVIDENCE REGARDING
MARKET EFFICIENCY
1. Weak form efficiency is very well supported, although a few
anomalies do exist
2. Semi-strong form efficient is well supported, but more
contradictory evidence exists for this version of the EMH
than for the weak form
3. Strong form efficiency is not very well supported by the
evidence, and it is reasonable to conclude that markets are
not strong form efficient in the strictest sense
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
25
10.5 BEHAVIOURAL FINANCE
• Behavioural finance is a field of financial thought that suggests investor
behaviour is not always rational but is influence by psychological biases
that cause investors to make systematic errors in judgement
• The “traditional view of finance” suggests that investors:
– Consider all available information
– Act rationally and do not make systematic errors, either in
processing information or in implementing decisions
– Adhere to the basic tenets of modern portfolio theory, which
implies they are risk averse, they diversify, and they consider risk in
the context of a well-diversified portfolio
• But, to quote a legendary investor, Peter Bernstein, evidence “reveals
repeated patterns of irrationality, inconsistency and incompetence in
the ways human beings arrive at decisions and choices when faced with
uncertainty.”
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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10.5 BEHAVIOURAL FINANCE
• Loss aversion causes an investor to place a heavier emphasis on losses
than on comparable gains.
• Unlike risk aversion, where investors dislike risk but are willing to
assume it if they are adequately compensated, loss aversion results in
investors seeking to avoid loss even if it results in suboptimal
investment decisions such as: investing too conservatively, holding on
to poor investments too long, or selling good investments too quickly
• Anchoring is the tendency to become emotionally tied to some initial
price or perception, so investors may be unwilling to sell an investment
that has lost value until they recover their investment even though the
investment is unlikely to regain its value
• Mental accounting is the process of accounting for individual
investments separately which can result in poor diversification and
inconsistent attitudes towards risk depending on the source of funds
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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10.5 BEHAVIOURAL FINANCE
• Bubbles are significant and generally unwarranted increases in asset
prices that lead to unsustainably high price levels
• Notable bubbles through history:
– Dutch Tulip Bulb Bubble (1636)
– South Sea Bubble and Mississippi Bubble (1720)
– U.S. Stock Price Bubble (1927 to 1929)
– Japanese Real Estate and Stock Price Bubble (1985 to 1989)
– Internet Stock Bubble (1995 to 2000)
– U.S. Real Estate Bubble and Sub-Prime Crisis (2000s)
• In bubbles investors exhibit herd-like behaviour, overconfidence and
fear of regret if they fail to participate in the bubble
• Investors also place heavier than normal emphasis on the importance
of recent (positive) events during bubbles, and discount past, less
spectacular returns as being unimportant or irrelevant to the future
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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10.6 IMPLICATIONS OF MARKET EFFICIENCY
• Empirical evidence suggests: markets react quickly and relatively
accurately to new public information
• Markets may not be perfectly efficient, but they are relatively
efficient
Implications for Investors
1. Technical analysis is not likely to be rewarded
2. Fundamental analysis is also unlikely to be successful at generating
abnormal profits after transaction costs and taxes
3. Active trading strategies are unlikely to outperform passive, buy-andhold strategies, favouring index mutual funds or exchange-traded
funds (ETFs)
4. Investors should focus on the basics of good investing by defining
investment goals in terms of expected returns and acceptable risk
levels
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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10.6 IMPLICATIONS OF MARKET EFFICIENCY
Implications for Corporate Officers
1. The timing of security issues or share repurchases is
unimportant because prices are correct, over average
2. Management should monitor the price of a firm’s
securities to see whether price changes reflect new
information or short-run momentum and/or
overreaction
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© John Wiley & Sons Canada, Ltd.
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