Midterms Flashcards
a theory in finance that suggests that financial markets are “informationally efficient,” meaning that asset prices always reflect all available information. This implies that it is impossible to consistently achieve higher returns than the market average because prices adjust quickly when new information becomes available
Efficient Market Hypothesis
suggests that stock prices always reflect all available information, making it impossible for investors to consistently outperform the market through stock picking or market timing. According to this, stocks are always priced fairly, meaning that it’s not possible to buy undervalued stocks or sell overvalued ones. The only way to achieve higher returns is by taking on more risk.
Efficient Market Hypothesis
Key Principles of EMH
- Information is Quickly Reflected
- Stock Prices Follow a Random Walk
- No Free Lunch
o Any new information (such as earnings reports, economic data, or company announcements) is almost instantly incorporated into stock prices.
o This means that prices adjust rapidly, making it difficult to “beat the market.”
Information is Quickly Reflected
o According to EMH, price movements are unpredictable because they are based on newly available information, which is random.
o If prices followed a predictable pattern, investors would exploit it, and the opportunity would disappear quickly.
Stock Prices Follow a Random Walk
o Since stock prices already reflect all known information, there are no “undervalued” or “overvalued” stocks that can be easily exploited for profit. o The only way to earn higher returns is by taking higher risks.
No Free Lunch
Real-Life Examples of EMH in Action
- Earnings Reports and Stock Prices
- Stock Market Reactions to News
o If a company announces higher-than-expected profits, the stock price will increase almost immediately.
o If profits are lower than expected, the stock price will drop. o Since this adjustment happens quickly, it is nearly impossible for investors to act on the news before the price changes.
Earnings Reports and Stock Prices
o If an economic crisis is announced, stock prices might fall right away as investors react.
o If a company is rumored to be acquired, its stock price might rise instantly. o Because prices react so fast, most investors cannot profit from public news.
Stock Market Reactions to News
His strategy of buying undervalued stocks has been very successful, leading some to argue that EMH doesn’t always apply.
Warren Buffett’s
Reasons the Market is Efficient
✅ Stock prices update fast
✅ Many smart investors
✅ Hard to beat the market
New information spreads quickly, and prices adjust almost instantly.
Stock prices update fast
Many smart investors
Thousands of professionals analyze stocks, making it hard to find “hidden” opportunities.
Studies show that most investors, even professionals, fail to earn better returns than the overall market
Hard to beat the market
Reasons the Market Might NOT Be Efficient
❌ People make emotional decisions
❌ Market bubbles and crashes ❌ Some investors beat the market
❌ Information Asymmetry
Main Theoretical Foundations
- Rational Expectations Theory
- Random Walk Theory
- The Law of One Price & Arbitrage
- Capital Asset Pricing Model (CAPM)
- Rational Expectations & Information Theory
- Behavioral Finance Challenges (Opposing Viewpoint)
EMH assumes that investors use all available information rationally to form expectations about future prices.
While individual investors may make mistakes, their errors are assumed to be random and cancel each other out, leading to an overall efficient market.
Rational Expectations Theory
This theory, proposed by Paul Samuelson, suggests that stock prices follow a “random walk,” meaning future prices cannot be predicted based on past prices.
Since all information is immediately reflected in prices, price changes occur randomly in response to new information.
Random Walk Theory
The principle of arbitrage states that identical assets should have the same price across markets.
If mispricing occurs, traders will quickly exploit it, driving prices back to their correct levels.
This mechanism contributes to market efficiency.
The Law of One Price & Arbitrage
The CAPM, developed by Sharpe, Lintner, and Mossin, explains the relationship between risk and expected return.
EMH aligns with CAPM by suggesting that only systematic risk is rewarded in the market, while diversifiable risk is not.
Capital Asset Pricing Model (CAPM)
Investors form their expectations based on publicly available and private information.
The market aggregates all this information efficiently, leading to fair asset prices.
Rational Expectations & Information Theory
Critics argue that cognitive biases, irrational behavior, and market anomalies challenge the EMH.
Concepts like herd behavior, overconfidence, and momentum trading suggest that markets may not always be perfectly efficient.
Behavioral Finance Challenges (Opposing Viewpoint)
The Three Forms of EMH (Levels of Market Efficiency)
- Weak Form Efficiency
- Semi-Strong Form Efficiency
Strong Form Efficiency
o Stock prices reflect all past trading data (such as price history and trading volume).
o Technical analysis (predicting prices based on past trends) does not work because past price patterns do not predict future prices.
o Example: If a stock has been rising for 10 days in a row, there’s no guarantee it will continue to rise on the 11th day.
Weak Form Efficiency
oStock prices reflect all publicly available information, including news, earnings reports, and financial statements.
o Fundamental analysis (evaluating company financials to find mispriced stocks) does not work because this information is already factored into stock prices.
o Example: If a company releases an earnings report, its stock price will already incorporate this information within seconds or minutes.
Semi-Strong Form Efficiency
o Stock prices reflect all information, including both public and private (insider) information.
o Even company executives with insider knowledge cannot consistently profit from trading stocks.
o Example: If an executive knows their company will be acquired and buys stock in advance, EMH suggests that this won’t help because the stock price already reflects this possibility.
Strong Form Efficiency
is an idealized decision-maker who makes choices to maximize personal benefit based on all available information. This concept is central to many economic theories, including EMH
Rational investor
According to this theory, people make rational decisions with complete, accurate information, aiming to maximize their utility.
Rational Actor Theory (RAT)
are individuals who make investment decisions based on emotions, biases, or misconceptions rather than logical analysis and sound financial principles. Instead of relying on data and careful study, they often react to fear, excitement, or herd mentality, leading to suboptimal financial choices.
Irrational investors
Examples of Irrational Investor Behavior:
Buying high and selling low
Following the crowd
Holding onto losing stocks
Overconfidence
Fear of missing out (FOMO) – Rushing into inv
Sources of Irrational Investment Behavior
- Overconfidence
- Pride and Regret
- Risk Perception
- Framing
- Mental accounting
- Heuristic Simplification
- Short-term focus
- Emotional influence
causes investors to overestimate their ability to predict market movements. Two key aspects include: Miscalibration – Underestimating the range of possible outcomes. Better-than-average effect – Believing oneself to be more skilled than the average investor, leading to excessive risk-taking.
Overconfidence
Investors tend to repeat actions that bring pride and avoid those that create regret. This leads to the disposition effect, where investors sell winning stocks too early and hold onto losing stocks too long. The perception of success or failure is influenced by their reference point rather than actual gains and losses.
Pride and Regret
Investors’ risk tolerance fluctuates based on their experiences:
House-money effect – After making gains, they take greater risks.
Snakebite effect – After losses, they become overly cautious. Trying-to-break-even effect – Seeking high-risk investments to recover losses quickly.
Endowment effect – Valuing assets they own more highly than identical assets they do not own.
Status quo bias – Avoiding action when overwhelmed by investment choices.
Risk Perception
How an investment is presented affects decision-making. Many investors focus on whether an investment seems “good” or “bad” rather than considering risk-adjusted returns.
Framing
Investors often separate their finances into different “mental accounts,” which leads to suboptimal decisions, such as failing to diversify properly. Behavioral Portfolio Theory (BPT) suggests that investors create portfolios in layers based on specific goals, rather than optimizing for overall returns and risk.
Mental accounting
To simplify complex financial decisions, investors use mental shortcuts (heuristics), which can lead to errors: Representativeness bias – Assuming good companies are always good investments. Familiarity bias – Preferring known investments over unfamiliar ones, leading to poor diversification.
Heuristic Simplification
The constant flood of financial news and market updates can cause investors to react impulsively, prioritizing short-term gains over long-term stability.
Short-term focus
Market bubbles and crashes are often fueled by greed and fear, leading to irrational buying and selling behaviors.
Emotional influence
THEORETICAL AND EMPIRICAL CHALLENGES TO THE EMH
- Different Investor Perspectives
- Unequal Profitability
- Market Outperformance
- Time Lag in Price Adjustments
- Random Events and Market Anomalies
EMH assumes that all investors interpret available information in the same way. However, investors use different strategies–some focus on undervalued stocks, while others prioritize growth potential. Since perspectives vary, determining a stock’s “true” value is subjective and contradicts the EMH.
Different Investor Perspectives
EMH claims that no single investor can consistently outperform others with the same resources since they all have access to the same information. However, real-world data shows a wide range of investment returns. If the hypothesis were true, every investor would achieve the same outcome, which is not the case.
Unequal Profitability
According to EMH, no investor should be able to beat the market over time. If true, the best strategy would be to invest in index funds that mirror overall market performance. Yet, many investors, such as Warren Buffett, have consistently outperformed market averages, contradicting EMH.
Market Outperformance
The hypothesis does not specify how quickly stock prices adjust to new information. In reality, markets take time to incorporate new data, allowing inefficiencies to persist longer than EMH suggests.
Time Lag in Price Adjustments
EMH acknowledges random price fluctuations but assumes they eventually correct themselves. However, market anomalies and speculative bubbles indicate that inefficiencies exist and persist over time, challenging the idea of absolute efficiency
Random Events and Market Anomalies
It happens when someone buys or sells stocks based on important company information that is not available to the public. This can include company employees, managers, or even outside investors who somehow gain access to private details.
Insider trading
is the attempt to determine the future price of stocks or other financial assets. If someone can accurately predict prices, they can make a profit. However, predicting stock prices is difficult because markets react to new information. Some experts believe stock prices follow a “random walk,” meaning they move unpredictably, while others believe certain methods can help forecast future movements.
Stock market prediction
is the actual worth of a company, determined through fundamental analysis. It considers both tangible and intangible factors, like company earnings, market position, and potential growth.
Intrinsic value
Stock Market Prediction Methods
- Fundamental Analysis
- Technical Analysis (Charting) 3. Technological Methods
