LM 3: Market Efficiency Flashcards
What is an informationally efficient market?
market were prices reflect all past & present information
What are 4 things affecting market efficiency? MILT
- market participants
- information availability & financial disclosure
- limits to trading
- transaction costs & information acquisition costs
What is the performance difference between an efficient market and an inefficient market?
efficient market cannot get consistent, superiors risk adjusted returns
inefficient market can outperform on a risk adjusted basis
What kind of information should efficient markets react too?
efficient markets should only react to unexpected information, expected news is already built into prices
What are the 3 degrees of market efficiency?
- weak
- semi-strong
- strong
What information is reflected in prices in a weak form market efficiency?
past market data (price and trading volume)
What information is reflected in prices in a semi-strong market efficiency?
public information & past market data (past price and trading volume information)
What information is reflected in prices in a strong market efficiency?
private information, public information, and past market data
Using technical analysis shows what kind of market efficiency?
weak form
What kind of market efficiency does fundamental analysis support?
semi-strong form
What kind of market efficient do portfolio managers benefit from?
none, studies show active portfolio managers do not beat the market on average. however, good to create an investment strategy based on ones objectives and constraints
What is a market anomaly?
change in a security’s price that cannot be attributed to new information.
What are 2 types of time series anomalies?
- calendar anomalies
- momentum & overreaction anomalies
What are calendar anomalies?
Anomalies that are linked to a particular time (eg. January effect)
What is momentum & overreaction anomalies?
momentum anomaly: observed tendency for rising asset prices to rise further and falling prices to keep falling.
overreaction anomaly: securities become excessively overbought or oversold due to psychological reasons rather than fundamentals.
What are 2 types of cross sectional anomalies, describe them?
- size effect (small cap outperformed big cap on risk adjusted basis)
- value effect (the observation that stocks with attractive valuations tend to outperform the market in the long term)
What are 4 other market anomalies besides time series & cross sectional? CEIP
- closed end investment fund discounts
- earnings surprise
- IPO
- predictability of returns based on prior information
What is closed end investment fund discounts anomaly?
Shares of closed-end funds trade on stock markets like other equity securities, but at a discount to their net asset value (NAV)
What is earnings surprise anomaly?
companies with positive surprise earnings announcements experience a prolonged period of abnormal positive security returns
What is initial public offerings anomaly?
companies that issue IPOs tend to set low offering prices so earn excess returns by purchasing IPO at offering price
What is Predictability of Returns Based on Prior Information anomaly?
equity returns are linked to factors including interest rates, inflation rates, volatility, and dividend yields.
What is one implication you must consider with market anomalies?
trading costs
What is behavioral finance?
Behavioral finance: area of study that proposes psychology-based theories to explain market outcomes and anomalies.
What are 8 behavioral finance biases that can cause or explain anomalies? LHOIRMCN
- loss aversion
- herding
- overconfidence
- information cascades
- representativeness
- mental accounting
- conservatism
- narrow framing
What is loss aversion and herding?
loss aversion: phenomenon where a real or potential loss is perceived by individuals as psychologically or emotionally more severe than an equivalent gain.
herding: investors take the same side as the market even if this is inconsistent with their own private information.
What is overconfidence & information cascades?
overconfidence: Investors are often overconfident in their own abilities
information cascades: when market participants influence decision of others by acting first
What is representativeness and mental accounting bias ?
Representativeness: assessing likelihood of event based on past event (police who are looking for a suspect in a crime might focus disproportionately on Black people in their search, because the representativeness heuristic (and the stereotypes that they are drawing on) causes them to assume that a Black person is more likely to be a criminal than somebody from another group.)
mental accounting: tendency to mentally sort our funds into separate “accounts,” which affects the way we think about our spending
What is conservatism and narrow framing bias?
Conservatism: Failing to incorporate new information in a timely manner
Narrow framing: when you focus on the details at the expense of the big picture.
What is portfolio window dressing?
when portfolio managers try to boost reported performance before publishing required reports
What is the characteristic of value stocks in terms of dividend yield, price to earnings, and market to book ratios?
Higher than average dividend yield
Low price to earnings
Low market to book ratios
What is the characteristic of growth stocks in terms of dividend yield, price to earnings, and market to book ratios?
low dividend yields
High price to earnings
High market to book ratios
What is data mining?
Data mining: when analysts run test or market data until a statistically significant relationship can be found and used to formulate a hypothesis.
What is the difference between market value and intrinsic value?
market value determined by market quotes and transactions
intrinsic value objective true value investors would get if they had all relevant quantitative and qualitative information
What is the degree of underpricing for IPO’s?
Difference between a stock at the end of its first day trading on a secondary market after an IPO and its issue price.
With respect to rational and irrational investment decisions, the efficient market hypothesis requires:
A. only market is rational
B. that all investors make rational decisions
C. that some investors make irrational decisions
A. only market is rational
What is weak form inefficient?
when investors earn abnormal returns by trading on the basis of past trends in price and volume.
What is semi-strong inefficient?
producing abnormal returns by active portfolio management of fundamental analysis
