11. Efficient Market Hypothesis Flashcards
What is the EMH? (3)
- Efficient market hypothesis
- price reflects information in the market
- price = PV of future cash flows
main message of EMH
Stocks always trade at their fair market value meaning it is impossible to consistently generate abnormal trading profits after accounting for T-costs, taxes and risk aversion
Abnormal profit
profit that is higher than the level of risk taken (e.g. if beta = 1 and market return = 10%, you would expect return of 10%, if it is higher than this is considered an abnormal profit)
Does EMH hold ?
No - there are a small group pf asset managers that can outperform the market, there are pricing anomalies (e.g. momentum) that provide abnormal profits
fund managers can outperform the market but not…
consistently
greatest anomaly of the stock market? why?
momentum - consistently provides higher returns as past winners continue to outperform for the next six months (momentum strategy –> investing in past winners)
Zero-cost investment strategy (4)
- borrow shares of past losers from broker (e.g. 1m)
- sell that 1m of shares –> short sell
- use 1m to buy past winners
- return to broker –> likely abnormal profit
If EMH holds, what will happen?
active fund managers will not have a job - currently analyse to find mispriced securities however, if EMH holds - all securities will be fairly priced
What about in the case that EMH holds, but collecting information is costly?
it may not be beneficial to collect information if costly. must consider price vs. benefit as if price > benefit this will cause losses.
If people stop collecting information, what will happen to the market?
no longer competitive as prices will stop reflecting information
If EMH holds bit information is cheap and not costless to acquire
most information will be reflected in prices, difficulty to find mis-priced securities as there will be little difference in opinion and hence, little trading
Which types of stocks are more likely to be mispriced? (3)
more risky
stocks where it is difficult to collect information
small-cap, growth, non dividend paying, less transparent stocks
If EMH holds and information is costless?
prices will reflect all information and there will be no trading as there is no difference in opinion = no active fund –> assuming trading requires a difference of opinion
Difference of opinion is important for ___ however, ___
trading however, some investors trade because of liquidity
Why do analysts and traders collect information?
to make profit
