Fin124 - Market Efficiency (1)

8/17/2019 Fin124 - Market Efficiency (1)

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Market Efficiency

Cocabo, Dayrit, Lok, Sasotona, Son


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Outline

I. The Concept of Market Efficiency

II. Forms of Market Efficiency

III. Evidence of Market Efficiency

IV. Implications for Analysis and Portfolio ManagemeV. Market Pricing Anomalies

VI. Behavioral Finance


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The Concept of Market Efficiency

Definition:

An efficient capital market is one wherein the prices

securities adjust rapidly to the arrival of new informa

therefore, the assumption is that the current prices o

securities reflect all the information about the securi


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First Assumption:

A large number of profit-maximizing participants ana

value securities, each independent of the others.


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Second Assumption:

New information regarding securities comes to the m

random manner, and the timing of one announceme

independent of others.


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Third Assumption:

The buy and sell decisions of the profit-maximizing i

cause security prices to adjust rapidly to reflect the e

new information.


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Price adjustment is imperfect, but unbiase● Market may overadjust or underadjust

● Impossible to predict which will occur at any give


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● Prices adjust quickly because investors compete

from new information

● Impossible to predict which will occur at any give

● Combined effect: price changes are independenrandom


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Therefore, in an efficient market, the expected retur

in the current price of the security should reflect its r

Investors should receive a rate of the return that is c

with the perceived risk of the security.


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Efficient Market Hypothesis (EMH)

The buy and sell decisions of the profit-maximizing i

cause security prices to adjust rapidly to reflect the e

new information.


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● Weak-Form EMH● Semistrong-Form EMH

● Strong-Form EMH

Forms of Market Efficiency:


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Weak-Form EMH

● Assumption: Current stock prices fully reflect all s

market information, including historical data

● Implication: Past rates of return and other historic

data have no relationship with future rates of retu

● Therefore: Gain little from using any trading rule

past rates of return/past security market data


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Weak-Form EMH Example:

1) A CEO of a firm has inside information about a pa

stock

2) He tells his friends first, who buy the stock before

public knows of this information

3) There is low efficiency in the market


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Semistrong-Form EMH

● Assumption: Current stock prices fully reflect all p

information, which also includes all nonmarket in

● Implication: Investors who trade based on these

public information cannot gain above-average be


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Semistrong-Form EMH Example:

1) CEO’s friends (company officers, insiders, family

know information slightly before the public

2) Information flows semi-quickly; those who are to

have a slight advantage


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Strong-Form EMH

● Assumption: Current stock prices fully reflect all

information from public and private sources

● Implication: No monopolistic access to informatio

to the formation of prices

● Therefore: No investor will be able to benefit mo

another since stock prices reflect all information


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Strong-Form EMH Example:

1) CEO, friends, and public learn of news about the

the same time

2) Nobody can have an advantage; there is no data

provide additional valuable information to investo


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Weak-Form Hypothesis: Tests and Results

I. Statistical Tests of Independence

A. Autocorrelation test → insignificant correlation in stock

time

B. Runs test → independence of stock price changes ove

II. Tests of Trading Rules

→ Most evidence show that most trading rules tested have able to beat a buy-and-hold policy


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Semistrong-Form Hypothesis: Tests and Res

I. Event Studies (examines how stock prices adjust to signific

economic events)

→ Ex. of events: stock splits, IPO, unexpected world/econom

etc.

→ Results mostly support the Semistrong-Form EMH

II. Time Series Analysis (determines whether any public info w

superior estimates of returns

→ Revealed evidence/anomalies that counters EMH


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Strong-Form Hypothesis: Tests and Results

Analyzed the performance of 3 major investment groups:

1. Corporate Insiders

→ apparently have monopolistic access to inside information

→ does not really support EMH

2. Security Analysts

→ have opinions/recommendations which can be considered sign

→ mixed results but more on supports EMH

3. Professional Money Managers

→ does not have access to inside information; does not outperfor

→ relatively supports EMH


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Evidence of Market Efficiency

It is impossible to regularly beat an efficient market

1. Random Walk Theory: Stocks take random, unpredictable paths.

a. Having accurately forecasted does not ensure that same inv

analyst will be lucky enough to do so again in the future.

2. Performance of investment analysts

a. For every person that “wins” in outperforming the market, th

“loser” to hold the equilibrium of the market


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Implications for Analysis and Portfolio Manag

Technical Analysis

- A method of evaluating securities by analyzing m

activity, such as past prices and volume

- Use charts and patterns to suggest future activity

- Cannot be used under any form of market efficieeven weak efficiency, prices already reflect past


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Fundamental Analysis

- Attempts to measure securities’ intrinsic value by

macroeconomic and company-specific factors (e

conditions, current management, etc.)

- Can only be used in weak form efficiency (in semform, prices already reflect current public informa


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Portfolio Management

- Goal of portfolio management: outperform a spe

benchmark with specific benchmark ideas

- Market efficiency implies that this is unachievable

portfolio manager should not be able to achieve average returns


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- No group of investors should be able to consiste

the market using a common investment strategy

- Efficient markets have self-correcting mechanism

inefficiencies appear regularly, but disappear as investors find them and trade on them


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- Thus, portfolio managers should focus on risk an

given that market efficiency implies that consiste

average returns are unachievable


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Market Pricing Anomalies

1. Small-firm effect

a. Greater amount of growth opportunities than large companiesb. More volatile business environment

c. Lower stock prices resulting to higher price appreciation

2. Calendar effects (January anomaly)

a. Stocks that underperform in the 4th quarter of last year tend to perf

even outperform the market in January

b. Losses are used to offset capital gains taxes

c. Stock prices increase in January due to an increase in buying, resul

drop in prices of stocks in December


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3. Low price-to-book value:

a. Underappreciated stocks moving towards average price to book ratio va

b. Could either mean than the stock is undervalued or

c. The company is underperforming

4. Reversals:

a. Yesterday’s top performers become tomorrow’s under performers and v

b. Top performing stocks become more expensive, while underperforming

cheaper

c. In relation to b, overpriced stocks perform less while undervalued stocks


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5. Neglected Firm

a. Caused by lack of information and interest

b. Once discovered by investors, the stock’s value will increase

c. However, research shows that this anomaly does not really e

d. Small firms look to outperform because of their size, but for

that are neglected, there is no real increase in performance.

6. Momentum

a. The price of a security will continue to move in the same dire

b. Used for short term movements in a stock’s price


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7. Days of the week: Behavioral finance theories

a. End of the week optimism (BF hypothesis)

i. Positive moods going into the weekend; Positive re

Friday, lots of trading

b. Start of the week pessimism (More cognitive evidence)

i. Investors update themselves on company news over

ii. Leads to risk-averse Monday decisions, market goes


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Behavioral Finance

Definition

Considers how various psychological traits affect ho

individuals or groups act as investors, analysts, and

managers (Reilly and Brown, 2012)


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Behavioral Finance

Three Factors

1. Psychology - Individual behavior

2. Social Psychology - Behavior affected by others

3. Neurofinance - Nature of cognitive processes tha

to our financial decisions


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Behavioral Finance

Explaining Biases

1. Holding “losers” for too long and selling “winners

soon (Investors fear losses more than they value

a. Belief perseverance - reluctant to change min

despite contrary informationb. Anchoring - starting with an arbitrary value fo

failing to adjust as time passes


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Behavioral Finance

Explaining Biases

2. Overconfidence in forecasting for growth compan

(Overemphasizing growth, focusing only on good ne

a. Confirmation bias or representativeness (actively looking for

b. Hindsight bias (people overvalue one person’s prediction aft

something right)

c. Self-attribution bias (success to personal effort, failure to bad


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Behavioral Finance

Explaining Biases

3. Noise traders (increase market volatility)

● overreact to news

● follow the herd

● have poor timing

4. Escalation bias

● rationalizes a bad investment through negative results, instead o

● allows investment to become a sunk cost


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Behavioral Finance

Fusion Investing

An approach that integrates both traditional and beh

paradigms to create a more robust investment mode

Basically, the application of behavioral finance into t


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Behavioral Finance

Fusion Investing

Example: Discounting securities indefinitely

● Takes into account future dividend/market trends and noise trade

● Fundamental finance variable, and behavioral finance variable


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Conclusion

Is there market efficiency?

● Most say markets can never be completely weak

implying that semi-strong efficiency is the most c

● Philippines: Leans towards weak efficiency (Aqui

○

Fair speed of information absorption, except during political/stress

○ Asymmetrical information disclosure: large shareholders inst

access to information for companies they control


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Conclusion

Is there market efficiency?

● “If all participants were to believe that the marke

efficient, nobody would seek extraordinary profit

the force that keeps the wheel of the market turn

● Age of IT: Electronic trading; prices adjust faster● However, not all information is quality informatio


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Sources

1) Investment Analysis & Portfolio Management (Reilly, Brown) 10th

2) “What Is Market Efficiency?”, “Securities Markets - Weak, Semi-St

Strong EMH,” “Market Anomalies,” www.investopedia.com. Acce

2016.

3) Informational Efficiency Characteristics of the Philippine Stock Ma

Aquino. 2006.
http://www.investopedia.com/

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Fin124 - Market Efficiency (1)

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