Equities: Market Efficiency Flashcards
Informational efficiency =
how well/fast is new information reflected in market prices.
We can measure this to see how efficient markets are.
If they are perfectly efficient, a passive strategy should win out
Market vs Intrinsic value =
In a perfectly efficient market the market price will reflect the intrinsic value of the asset
Factors affecting the efficiency of markets =
- number of participants
- availability of information
- impediments to trading/arbitrage - note that the ability to short sell improves potential for efficiency
- transaction and information costs
Fama’s three forms of market efficiency =
- weak-form: security prices fully reflect all currently available security market data - ie past volumes and prices - on average you cannot obtain positive risk adjusted returns from technical analysis
- semi-strong form: fully reflect all publicly available information, incl past - on average you cannot achieve positive risk adjusted returns from fundamental analysis.
- strong-form: fully reflect all information from both public and private sources - no-one should be abe to consistently achieve positive abnormal returns
evidence supports the view that markets are not strong-form efficient
Abnormal profit =
aka risk adjusted returns
used to calculate how efficient a market is.
ie if returns on average are greater than equilibrium expected returns we can conclude markets aren’t efficient
Technical analysis =
evidence supports that markets are weak-form efficient and technical analysis does not produce abnormal profits
although it may be more profitable in emerging/less efficient markets
Fundamental Analysis =
evidence suggests that markets are semi-strong form efficient, which raises questions about the use of fundamental analysis
- fundamental analysis may bring about informationally efficient market prices
it may also be useful for those who are exceptionally skilled at it, or those who can act before other market participants can
Passive vs Active =
in semi strong form efficient markets investors should invest PASSIVELY
Anomaly studies =
tests of the efficient markets hypothesis - a market anomaly is something would lead us to reject EMH
Calendar anomalies =
January effect/turn of the year effect - prices fall at the end of december and rise in early Jan (tax loss harvesting?)
after adjustment for risk, the january effect does not seem to persist over time
Overreaction and momentum anomalies =
overreaction: market overreacts, undervalues ‘losers’ and overvalues ‘winners’ in reaction to unexpected information
momentum: high short term returns are followed by continued high returns
Other anomalies =
size effect - small cap outperforms
value effect - value outperforms
closed end funds trading below NAV
earnings announcements - go long those who will have upside earnings announcements and sell those with downside announcements
IPOs - typically underpriced
MAJORITY OF ANOMALIES APPEAR TO BE THE RESULT OF METHODOLOGIES USED TO TEST EMH, AND ARE NOT ACTUALLY VIOLATIONS OF MARKET EFFICIENCY - AND IF THEY ARE ONLY PRESENT SHORT TERM THEIR IMPACT IS AVERAGED OUT OVER THE LONG RUN
Behavioural analysis and EMH =
behavioural theories suggest market participants are not necessarily rational.
if rational behaviour is a prereq for efficient markets then this is a counter argument to EMH
if EMH only requires that investors cannot consistently earn abnormal risk adjusted returns, behavioral research supports EMH
examples of behavioral biases:
- representativeness (investors assume good companies/markets are a good investment)
- gamblers fallacy (recent results affect investor’s probability estimates for the future)
- mental accounting (consider investments singly, not as a portfolio)
- conservatism (react slowly)
- disposition effect (don’t realize losses, only gains)
- narrow framing (view events in isolation)
- cascades/herding (investors follow other investors - can be uninformed investors following informed investors however)
