Lecture 4 Efficient Market Hypothesis and Efficiently Inefficient Markets

Question 1

Efficient Market Hypothesis (EMH)

What is the Efficient Market Hypothesis (EMH)?

Answer 1

EMH states that stock prices fully reflect all available information and adjust instantaneously to new information, making it impossible to consistently achieve abnormal returns without taking on additional risk.

link to Random Walk Hypothesis

Question 2

Random Walk Hypothesis

What is the Random Walk Hypothesis in EMH?

Answer 2

Price changes are unpredictable because news is unpredictable:

Grossman and Stiglitz (1980) - argue that markets can’t be fully efficient, as costly information must be rewarded, but competition ensures any opportunities are quickly exploited.

Question 3

Types of Market Efficiency

What are the types of market efficiency under EMH?

Answer 3

1. Weak Form: Prices reflect historical data (e.g., past prices, volumes)
2. Semi-Strong Form: Prices reflect all public information (e.g., earnings, announcements)
3. Strong Form: Prices reflect all information, including insider information

Question 4

Implications of EMH

What does EMH imply for technical and fundamental analysis?

Answer 4

• Technical Analysis: Useless because historical price trends are already reflected in the current price.
• Fundamental Analysis: Only works if one’s estimate of intrinsic value is better than the market’s.

Link to the three forms of EMH (Weak, Smei-strong, Strong)

Question 5

Evidence Against EMH

What evidence challenges EMH?

joint hypothesis problem

Answer 5

1. Momentum: Researchers found that stocks doing well over the past year often continue to do well for a bit (momentum). Jegadeesh and Titman (1993)
2. Reversal: On the flip side, stocks that do really well over five years tend to underperform afterward.
3. Anomalies: After good news (like positive earnings surprises), stocks sometimes drift upwards for a while before stabilizing, suggesting that prices don’t adjust instantly Basu (1977)

Joint hypothesis problem, which suggests that any observed anomaly (e.g., abnormal returns) could either mean:

• Market inefficiency (prices don’t fully reflect information),
• The risk model used is flawed, failing to account for all relevant risks properly.

Question 6

Behavioral Finance

How does behavioral finance challenge EMH?

Answer 6

Behavioral finance argues that investor biases, such as overconfidence and conservatism, lead to market inefficiencies.

Question 7

Key Behavioral Biases

What are common behavioral biases in finance?

Answer 7

1. Overconfidence: Overestimating one’s ability or accuracy of forecasts.
2. Conservatism: Underreacting to new evidence.
3. Disposition Effect: Selling winners too early and holding losers too long.
4. Prospect Theory: Loss aversion influences decision-making.

Question 8

Limits to Arbitrage

What are the limits to arbitrage that hinder market correction?

Answer 8

Fundamental Risk: Prices may not revert quickly, increasing risk. (Gromb and Vayanos, 2010)

Idiosyncratic Risk: Firm-specific risks can deter arbitrage. (Pontiff, 2006)

Short-Sale Constraints: High costs limit arbitrage opportunities.

Question 9

Efficiently Inefficient Markets

What is the concept of efficiently inefficient markets?

Answer 9

Markets are almost efficient due to competition, but inefficiencies remain to compensate skilled managers for their costs and risks.

Question 10

Momentum Strategies

What are momentum strategies?

Answer 10

Momentum strategies involve buying past winners and selling past losers. Evidence shows that stocks with strong short-term alphas continue to perform well.

Question 11

Value Investing

What are common value investing strategies?

Answer 11

Value strategies focus on buying “cheap” stocks using measures like:
* Book-to-Market (B/M).
* Price-to-Earnings (P/E).
* Cash Flow-to-Price (CF/P).

Question 12

Performance of Value Strategies

Is value investing still effective?

Answer 12

Critics argue value strategies are outdated due to changes like intangible assets. However, evidence shows value investing remains viable with adjustments.

Question 13

Value Investing

Is value investing truly obsolete, or can it still be a profitable strategy? Explain the main arguments supporting its continued viability.

Answer 13

• Multiple Fundamentals Needed:
  Relying solely on one metric like book-to-price is inadequate.
• Handling Share Repurchases:
  Declining book value from buybacks increases residual earnings –> less shares higher prices
• Intangible Assets Consideration:
  Adjusted metrics accounting for R&D and advertising still support value strategies.

Question 14

Covidomics

What were the effects of pandemics on financial markets?

Answer 14

Research shows pandemics reduce real interest rates due to increased savings and lower capital investment demand, unlike wars, which increase rates.

Question 15

Behavioral Explanation of Market Anomalies

Why might small, low P/E, and previously underperforming (“loser”) stocks earn higher future returns according to behavioral explanations?

Answer 15

• Low P/E, small stocks often fell in price—risk or mispricing?
• Risk view: Size and value reflect distress risk (Fama & French).
• Behavioral view: Analysts over-extrapolate performance, leading to overpriced “winners” and underpriced “losers” (Lakonishok et al.).
• Investor biases cause systematic mispricing.