Are Financial Markets Are Financial Markets Efficient?Efficient?

Overview of PresentationOverview 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: Disclaimer: I am not trying to sell you anythingI am not trying to sell you anything

Disclaimer: Disclaimer: I am not trying to sell you anythingI am not trying to sell you anything

Disclaimer: Disclaimer: I am not trying to sell you anythingI am not trying to sell you anything

In 1990s, Dow went berserk!In 1990s, Dow went berserk!

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Dow Jones Industrial IndexMonthly Close, May 1949 - April 1999

Don’t be amazed; we have been down Don’t be amazed; we have been down this road before...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...Famous Last Words...

“Stock prices have reached what looks like a permanently high plateau.”

Professor Irving FisherYale UniversityEarly Autumn, 1929

What is an Efficient Market?What is an Efficient Market?

“A market is efficient with respect to information set if it is impossible to make economic profits by trading on the basis of information set .”

Michael C. Jensen

“Some Anomalous Evidence Regarding Market Efficiency.”

Journal of Financial Economics 6 (1978): 95-101.

t

t

Huh????Huh????

Translation:

– after accounting for transactions and

information costs, you can’t beat the

market on a risk-adjusted basis.

Some markets are amazingly Some markets are amazingly efficient...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 Until recently, evidence strongly supported market efficiency…supported market efficiency…

• Stock returns were unpredictable.

• Stock prices rapidly reacted to new information (Event Studies).

• Actively managed mutual funds turned in dismal records.

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?

$171,950

$311,000

Mutual Funds S & P Index Fund

Poor Record of Mutual Funds: An Poor Record of Mutual Funds: An ExampleExample

Source: Burton G. MalkielA Random Walk down Wall Street

But, then troubling new But, then troubling new evidence began to emerge...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 vice-versa.

More Troubling Evidence: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 Perhaps, the most troubling puzzle: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 This new evidence has led to the rise of a new school to the rise of a new school of thought in academia...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)ArbitrageArbitrage—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 Implication of Behavioralism:Behavioralism:

• You can make money exploiting predictable patterns in securities prices.

But wait…But wait…New evidence may not be fatal to New evidence may not be fatal to

efficient markets hypothesis: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: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.

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: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: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: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.

The new evidence may not be fatal:The new evidence may not be fatal:

How do you explain the brokers How do you explain the brokers puzzle?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?What’s the point of all this?

• To overthrow efficient markets paradigm, you need:– damning evidence.– a better model.

Behavioralists have neither!Behavioralists have neither!

“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 And I have yet to make a nickel on any of these supposed market inefficiencies.”supposed market inefficiencies.”

Richard RollProfessor of FinanceUCLA

LessonsLessons from the Real Worldfrom the Real World

Bottom Line:Bottom Line:The stock market is The stock market is

efficient. There is no way to efficient. There is no way to get rich quick.get rich quick.

Efficient Market Lessons Efficient Market Lessons for Investingfor Investing

– Take more risk– commit fraud

Only two ways to post consistently high returns:

Remember:Remember: Brother Ty’s Seventh Law of Brother Ty’s Seventh Law of

Spiritual and Financial GrowthSpiritual and Financial Growth

• “The only way to get rich from a get-rich book is to write one.”

Source: Christopher Buckley and John TierneyGod is My Broker

Efficient Market LessonsEfficient Market Lessons for Investing for Investing

Invest in an stock index fund and hold:

– don’t pick stocks

– don’t try to time market

Mark TwainPudd’nhead Wilson

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

Efficient Market Lessons Efficient Market Lessons for Investingfor Investing

• How much of your wealth should you hold in stocks?– A lot… even more if you are young

How to use a broker:How to use a broker:

• Use him as a financial planner.

• Let him educate you about risk- return trade-offs.

• Don’t let him pick stocks for you.Don’t let him pick stocks for you.

Beware: Beware: A Fool and His Money are Soon Parted...A Fool and His Money are Soon Parted...

Beware: Beware: A Fool and His Money are Soon Parted...A Fool and His Money are Soon Parted...

Beware: Beware: A Fool and His Money are Soon Parted...A Fool and His Money are Soon Parted...

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