8.1. Market Efficiency Flashcards
Market efficiency…
Stocks follow a random walk (they do not move in neat patterns).
This random pattern is the natural outcome of market that are highly efficient and respond to new information quickly.
Efficient market hypothesis…
Suggests stock prices rapidly incorporate new information.
The more information that is incorporated into stock prices and the quicker that happens indicates a greater market efficiency.
An efficient market suggests that an investor cannot make abnormal returns.
The return on a stock (above the risk free rate) should equal its beta times the return on the market.
return-risk free return = beta*(market return - risk free return)
Abnormal returns = return - risk free return - beta*(market return - risk free return)
Nine conditions of an efficient market…
To score:
- 1: recall between 0-5
- 2: recall 6.
- 3: recall 7.
- 4: recall 8.
- 5: recall all 9.
- There are a large number of rational, profit-maximising investors.
- Individuals cannot affect market prices.
- Information is costless and widely available, generated in a random fashion.
- Investors react quickly and fully to new information.
- The market are highly liquid (with large cap companies being more liquid compared to small cap companies).
- There is intense buying and selling pressure.
- Share prices reflect all information available.
- Share prices respond instantaneously to new information.
- Investors cannot consistently make abnormal returns (beat the market).
Making abnormal returns…
Stocks always trade at their fair value, making it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices.
It should be impossible to outperform the market through expert stock selection and market timing.
Investors can make abnormal returns by chance or through purchasing risky investments.
Horizon Technology Finance Corp (HRZN) has a beta of 1.23, the risk free rate is 2.15% and the overall market return is 10%.
Expected return = 11.81%
If an investor earns 15%,
Abnormal returns = 3.19%
Beta / covariance / variance equation…
Beta = covariance / variance
Weak form EMH…
Share price incorporates all information contained in past share price data, including:
- Security price patterns.
- Trading volume.
- Volatility of security price patterns.
This means there is no chance to take advantage of past returns to predict future returns.
Investors should purchase a diverse portfolio and hold it.
Momentum may help investors to make profits in the future.
Semi-strong form EMH…
Share prices incorporate all publicly available information, including:
- Past share price information (security price patterns, trading volume and volatility of security price patterns).
- Accounting information, economic forecasts and industry forecasts.
Fundamental analysis and observing accounting information does not help investors beat the market.
Any price anomalies are quickly discovered and the stock market adjusts.
The way investors can make profit is by having private information and investing accordingly (illegal insider trading).
Strong form EMH…
Share prices incorporates all publicly and privately held information:
- Past share price data (security price patterns, trading volume and volatility of security price patterns).
- Publicly available information.
- Privately held data (i.e. the director’s insider information).
There is no information anywhere that allows investors to consistently earn abnormally high returns.
Even insider trading would not be possible.
Five implications of the EMH…
To score:
- 1: recall between 1-2.
- 2: recall 3.
- 3: recall 3.
- 4: recall 4.
- 5: recall 5.
- Technical analysis does not work if weak form holds.
- Fundamental analysis of the firm’s intrinsic value does not work if semi-strong form holds.
- Indices are a more efficient form of investment.
- Professional money managers will spend less time on individual securities, using passive investing.
- Tasks if the market is informationally efficient, maintain correct diversification and minimise transaction costs.
Five market anomalies…
To score:
- 1: recall between 1-2.
- 2: recall 3.
- 3: recall 3.
- 4: recall 4.
- 5: recall 5.
- Calendar effect: stock returns may be closely tied to the time of year. For example, the January effect where small-cap companies outperform large cap companies in January.
- Small-firm effect: small firms tend to earn abnormally positive returns. Small firms may offer higher returns than larger firms, even after adjusting for risk.
- Post-earnings announcement drift: stock price adjustments may continue after earnings have been announced. Creates an opportunity for investors to earn abnormal returns by purchasing stocks that have recently issued good earnings news or by short selling stocks that have recently delivered poor earnings results.
- Momentum: the tendency for stocks that have gone up recently to keep going up and vice versa.
- The value effect: on average, low P/E ratio stocks outperform high P/E ratio stocks.
Explanations of anomalies in the market…
Stocks that appear to earn abnormally high returns are actually riskier than other stocks, so higher returns merely represent compensation for this risk.
Some anomalies may simply be patterns in that data that appear by chance and are thus not likely to persist over time.
Behavioural finance: market participants may make systematic mistakes when they invest and those mistakes can create inefficiencies in the market.
Rationality as a principle of behaviour often holds, however some investors may have biases towards stocks that create inefficiencies.
Nine types of investor behaviour…
To score:
- 1: recall between 0-5
- 2: recall 6.
- 3: recall 7.
- 4: recall 8.
- 5: recall all 9.
- Overconfidence: investors tend to be overconfident in their judgement or ability and leads to them underestimating risk.
- Self-attribution bias: investors tend to take credit for success and blame factors out of their control for their failures. These biases can cause them to trade too often and can lead to higher transaction costs (reducing overall returns).
- Loss aversion: investors generally display risk-averse behaviour when confronting gains and risk-seeking behaviour when confronting losses. Because of this, investors may be reluctant to sell their losses, despite the fact they are tax deductible. Prospect theory (losses loom larger than gains). Investors hold onto stocks longer than they should which creates bigger losses.
- Overreaction: investors overreact to a string of good performance and overestimate the likelihood the trend will continue, resulting in investment performance below the market average.
- Underreaction: investors may underreact to new information.
- Belief perseverance: investors tend to ignore information that conflicts their existing beliefs. Investors who believe a stock is a good purchase may tend to discount any signs of trouble.
- Anchoring: investors place too much weight on information they have at hand. They may predict future market return on recent past returns.
- Familiarity bias: investors buy stocks they are familiar with reducing the diversification of a portfolio.
- Herding effect: when institutional managers invest similarly, this creates a self-reinforcing herding effect. It also occurs as individual investors tend to act in a similar manner, pushing the price of stocks in one direction in a significant manner.
Implication of behavioural finance for security analysis…
Identify psychological factors that can lead investors to make systematic mistakes.
Determines whether those mistakes may contribute to predictable patterns in stocks.
If that is the case, the mistake of some investors may be the profit opportunities for other investors.
