FNCE 625 – Investment Analysis and Management

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Investments: Analysis and Management

Fourteenth Edition

Gerald R. Jensen and Charles P. Jones

Chapter 12

Market Efficiency

Efficient Markets 1

In perfectly efficient markets, all securities are priced correctly

Information is key

Prices quickly and fully reflect all available information

Prices offer expected return consistent with risk level

Prices reflect past, current, and reasonably inferred information

Price adjustments are not perfect, but are unbiased

Efficient Markets 2

The Adjustment of Stock Prices to Information

Conditions for an Efficient Market

Large number of rational, profit-maximizing investors

Actively participate in the market

Individuals cannot affect market prices

Information is costless, widely available, generated in a random/independent fashion

Investors react quickly and fully to new information

U.S. security markets are likely efficient

Market Efficiency Forms

Efficient market hypothesis (E M H)

To what extent do securities markets quickly and fully reflect particular information?

Three levels of Market Efficiency

Weak form - market-level data

Semistrong form - public information

Strong form - all (nonpublic) information

Weak Form

Prices reflect all past price and volume data

History of price information is of no value in predicting price changes

Technical analysis, which relies on past price history, is of no value in assessing future changes in price

Market adjusts or incorporates this information quickly and fully

Believer in weak form could trade actively

Semistrong Form

Prices reflect all publicly available information

Investors cannot benefit from new public information after its announcement

Encompasses weak form as a subset

Strong Form

Prices reflect all information, public and private

No group of investors should expect to earn abnormal returns by using publicly or privately available information

Encompasses weak and semi-strong forms as subsets

Investor who believes in strong form should be passive

Testing for Market Efficiency 1

Market efficiency tests are tests of two hypotheses:

The market is efficient

Abnormal returns are measured correctly

Market-adjusted returns

Risk-adjusted returns

C A P M and market model

Match to similar firm

Multi-factor models

Testing for Market Efficiency 2

Keys:

Consistency of returns in excess of risk

Length of time over which returns are earned

Economically efficient markets

Assets are priced so that investors cannot exploit any discrepancies and earn unusual returns

Transaction costs matter

Weak-Form Tests

Statistical tests for independence (randomness) of stock price changes

If independent, trends in price changes cannot be profitably exploited

Test specific trading rules that attempt to use past price data

Account for costs, compare to buy-and-hold

Statistical dependence not the same as economic dependence

Semistrong-Form Tests

Event studies

Empirical analysis of stock price behavior surrounding a particular event

Examine company-unique returns

Residual error between security’s actual return and index model prediction: abnormal return

Abnormal return (Arit) = Rit − E(Rit)

Cumulative abnormal return (C A R) is sum of Arit over time

Strong Form Evidence

Test performance of groups which have access to “true” nonpublic information

Corporate insiders have valuable private information

Evidence that many have consistently earned abnormal returns on their stock transactions

Insider transactions must be publicly reported

Information can mislead investors

Market Anomalies 1

Exceptions that appear to be contrary to market efficiency

Earnings announcements affect stock prices

Effect must be separated into expected and unexpected

Unexpected requires price adjustment

In efficient market, prices should adjust quickly

Research shows substantial post-announcement adjustment for some stocks

This lag is contrary to efficient market theory

Market Anomalies 2

Low Price Multiple Ratios (e.g. P/E, P/S, P/B)

Evidence that low price multiple stocks tend to outperform high price multiple stocks

Rigid adherence could lead to poor diversification

Size effect

Small firms tend to have higher risk-adjusted returns than large firms

January effect

Small-firms tend to produce abnormal returns in January

Market Anomalies 3

Past stock price performance

In the short-run, stocks continue recent performance – they have momentum

In the long-run, stock performance reverses

Firm quality – more profitable firms perform better

Asset growth – firms with greater asset growth show weaker performance

Market Anomalies 4

Value Line Ranking System

Advisory service that ranks 1,700 stocks from best (1) to worst (5)

Probable price performance in next 12 months

Best investment letter performance overall

Transaction costs may offset returns

Data mining could find patterns/techniques that have no basis

Behavioral Finance 1

Suggests that various psychological traits influence investor pricing of securities

Modern Portfolio Theory (M P T) assumes investors are rational, risk averse, and consider investment decisions in a portfolio context

Behavioral Finance assumes investors are irrational, loss averse, and separate investment decisions

Behavioral Finance 2

Assumes emotions and biases affect markets

Investors make errors, markets over- & under-react

Investors can profit from others’ errors

Market constraints prevent full price adjustments

Psychology can cause market prices to diverge from fundamental values for long periods

Behavioral biases are detrimental to wealth

Types of Behavioral Biases 1

Emotional biases – an irrational spontaneous reaction based on state of mind

Loss aversion – losses are over emphasized

Overconfidence – investors place too much confidence in their investment knowledge

Familiarity – familiar stocks are over-weighted

Other emotional biases: status quo, regret aversion, self control, endowment, snake-bit effect, house-money effect

Types of Behavioral Biases 2

Belief perseverance biases – irrational actions to avoid mental discomfort

Confirmation – investors gather info. supporting their beliefs

Hindsight bias – remember predictions as more accurate than true

Illusion of control – belief in undue control

Other B P biases: representativeness and conservatism

Types of Behavioral Biases 3

Information processing biases – processing and using information irrationally

Anchoring and reference points – establish a default number as basis of decision

Framing – decisions depend on format of issue

Mental accounting – funds considered as separate/independent accounts

Availability bias – memorable events are considered more likely

Conclusions About Market Efficiency 1

Many market observers convinced of efficiency

Others are convinced they can outperform market

This belief increases market efficiency

Historical returns suggest market is efficient

Some anomalies appear to exist, but could result from insufficient tests or data

Recent bubbles and crashes at odds with efficient market, may support behavioral finance

Conclusions About Market Efficiency 2

Operationally efficient markets imply that some investors with the skill to detect a divergence between price and semistrong value earn profits

Excludes the majority of investors

Anomalies offer opportunities

Controversy about the degree of market efficiency still remains

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FNCE 625 – Investment Analysis and Management

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