CHAPTER 9: MARKET EFFICIENCY

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CHAPTER 9 MARKET EFFICIENCY
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Chapter Summary

• Objective To discuss the efficient market
  hypothesis and to examine the empirical evidence
  supporting or not the notion of market
  efficiency.
• The Efficient Market Hypothesis
• Empirical Tests of Market Efficiency

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What is the Efficient Market Hypothesis (EMH)?

• Stock prices reflect all available info
• Why? If info says its underpriced, everyone will
  buy it and price will go up
• Random Walk - stock prices change unpredictably
  and randomly
• Actually stock prices follow a submartingale
  (next slide)
• Expected price is positive over time
• Positive trend and random around the trend

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Random Walk with Positive Trend
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Random Price Changes

• Why are price changes random?
• Prices react to information
• Flow of information is random
• Therefore, price changes are random

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EMH and Competition between fund managers

• Stock prices fully and accurately reflect
  publicly available information
• Once information becomes available, market
  participants analyze it
• Competition assures prices reflect information

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If markets are efficient, why research?

• Research is expensive
• Research wont be done for ALL stocks

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3 forms of EMH
Weak form
Semi-strong form
Strong form
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Forms of the EMH(3 versions of EMH)

• Versions of EMH define available info
• Weak all past market trading information
• Semi-strong all publicly available information
  regarding the prospects of a firm
• Strong all information relevant to the firm

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Implications of EMH for investors

• Technical Analysis - using prices and volume
  information to predict future prices
• EMH waste of time
• Fundamental Analysis - using economic and
  accounting information to predict stock prices
• EMH waste of time

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Implications of EMH

• Investors make a fair return on their investment
• Markets will be efficient only if enough
  investors believe they are not efficient
• Public strategies cannot generate high returns
• Some portfolio mgrs will be consistently good

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Market Efficiency and Portfolio Management

• EMH advocates passive investment strategy
• (ie. Buy and hold)
• Is there a role that exists for portfolio
  management?
• It costs to analyze securities
• Diversification
• Appropriate risk level know your client
• Tax considerations

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Summary Reminder

• Objective To discuss the efficient market
  hypothesis and to examine the empirical evidence
  supporting or not the notion of market
  efficiency.
• The Efficient Market Hypothesis
• Empirical Tests of Market Efficiency

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Empirical Tests of Market Efficiency

• Event studies
• Assessing performance of professional managers
• Testing some trading rules

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What do EMH tests reveal?
Anomalies to EMH exist

• Small Firm Effect (January Effect)
• Neglected Firm
• Book to Market Ratios
• Reversals
• Weekend effect
• Post-earnings announcement drift

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Mutual Fund and Professional Managers Performance

• Do professional managers beat the market?
• EMH has some anomalies
• Some evidence of persistent positive and negative
  performance of various mgrs
• Superstar phenomenon
• eg. Peter Lynch, Warren Buffet
• Mutual funds do not outperform index