Lecture 9 - Efficient Markets Flashcards
What is efficient market?
The price of securities will fully reflect all information that is publicly known about those securities.
- Instantaneous and unbiased
Usually requires many rational investors.
How do market prices fully reflect all public information?
2 factors
- Investors individual estimates must be on average ‘unbiased’
- On average market is correct
- Assume decisions are independent (not correlated)
3 consequences for risk averse investor
- Investing is a fair game – can’t earn abnormal returns.
- Normal rate of return for the systematic risk.
- Random walk à today’s change in price will not tell anything about tomorrow.
- Naive investor à price protected (no adverse selection)
Efficient Market Hypothesis (EMH)
Robert Shiller:
- Stock price fluctuated more than dividends
- Investors are pricing expected future cash flows à only future cash flows are priced
4 implications of efficient for Financial reporting
- Accounting policy will not impact security price
- No difference between disclosure and recognition.
- E.g. depreciation method
- Investors are only interested in future cash flows and dividends
- Full disclosure enhances efficient
- Accurate prices (lack of adverse selection)
- Naïve Investors are price protected
- Accountants in competition
Competition with other sources à incentive to provide relevant, reliable, timely and cost effective information.
Conditions necessary for an efficient market to exist
- All investors are utility maximisers
- Bayes rule is followed (i.e. rational expectations)
- Assume errors equal 0
3 conditions that are required for an inefficient market
- Individuals are not perfectly rational
- Over or under react
- Individuals investors’ mistakes are the same
- E.g. correlated bias à ensures bias is not cancled out.
- Limited arbitrage:
- Existence of some rational investors should not be sufficient to make markets efficient
- E.g. sophisticated investors (investment banks), are unable to sway markets back to efficiency.
Outline 3 biases relevant to processing new information.
- Representativeness bias (Kahneman and Tversky, 1982)
- Conservatism Bias (Edwards, 1968)
- Other biases: over confidence and biased self-attribution.
How does representativeness Heuristic impact efficiency in the market?
People judge similarity to familiar types.
e.g Artistic woman would be associated with a sculptress, rather than a bank teller.
Guess should be based on base rate.
Law of small numbers:
- people see patterns in small sample
- When in reality is should be a random walk
E.g. recent high growth sales à indicate a patter of success.
How does conservatism impact efficiency in the market?
Investors are slow to update beliefs
- Underweight sample information
- Can result in:
- E.g.
- Short term momentum in stock returns
post earnings drift 3-12 month drift
How does overconfidence impact efficiency?
- Too much faith in their ability to process information
- Investors overreact to private information, in regard to company’s prospects.
How does self attribution impact efficiency?
Over or under reaction:
- Attribute success to our skills
- Failures to the external environment
Contradictory evidence is viewed as due to chance, thus discounted.
How does limited attention/bounded rationality impact efficiency?
Can’t process all the information in the market.
Lead to poor decisions.
What is the difference between classic and prospect theory?
Classic: investors should rank choices according to the utility from expected wealth levels.
Prospect Theory suggests that individuals make decisions on changes in wealth.
- i.e. gains or loses to some reference point.
- Becomes risk seeking to avoid losses, the ‘hurt’ of a $100 loss is more painful than a $100 gain.
- Perceived payoff asymmetry.
e.g. Gambler goes into casino with $20, if below this amount, will continue to gamble to not make a loss (risk seeking).
This results in 2 consequences called the disposition effect:
- Cash out gains too early (risk aversion)
Hold onto losses until it turns around (risk seeking)
Why must individual investors’ errors/biases be correlated?
Why may this be rational?
To ensure an inefficient market, people’s errors must not cancel out, i.e. one be buy one be sell.
People share similar heuristics