Reading 38: Market Efficiency Flashcards
Explain behavioral finance and name the various biases.
Behavioral finance looks at investor behavior to explain why individuals make the decisions they do, whether the decisions are rational or irrational. It is based on the premise that individuals do not always make efficient investment decisions or act rationally, due to the presence of behavioral biases. The existence of these biases has been offered as a possible explanation for a number of pricing anomalies.
Loss aversion and herding
Overconfidence and information cascades
Representativeness
Mental accounting
Conservatism and narrow framing
Distinguish between market value and intrinsic value.
The market value or market price of the asset is the price at which the asset can currently be bought or sold. It is determined by the interaction of demand and supply for the security in the market. Intrinsic value or fundamental value is the value of the asset that reflects all its investment characteristics accurately. Intrinsic values are estimated in light of all the available information regarding the asset; they are not known for certain.
Describe the three forms of the efficient market hypothesis (EMH).
Weak:
Current stock prices reflect all security market information
Future returns on a stock should be independent of past returns or patterns
Semi-strong:
Current security prices fully reflect security market and other public information
Encompasses weak-form EMH and includes nonmarket public information
Strong:
Stock prices reflect all public and private information
Implies that no group of investors has sole access to any information that is relevant in price formation
Why are investment managers and analysts interested in market efficiency?
In an efficient market, it is difficult to find inaccurately priced securities. Therefore, superior risk-adjusted returns cannot be attained in an efficient market, and it would be wise to pursue a passive investment strategy, which entails lower costs.
In an inefficient market, securities may be mispriced, and trading in these securities can offer positive risk-adjusted returns. In such a market, an active investment strategy may outperform a passive strategy on a risk-adjusted basis.
When do certain short-term share price patterns arise?
As a result of investors overreacting to the release of new information. Investors tend to inflate stock prices of companies that have released good news and depress stock prices of those that have released bad news.
Explain the size effect.
Shares of smaller companies outperformed shares of larger companies on a risk-adjusted basis.
Name the factors that contribute to and impede a market’s efficiency.
Market participants
Information availability and financial disclosure
Limits to trading
Transaction costs and information-acquisition costs
Differentiate between technical analysis and fundamental analysis in efficient markets.
Technical analysts utilize charts to identify price patterns, which are used to make investment decisions.
Fundamental analysts are concerned with the company that underlies the stock. They evaluate a company’s past performance and examine its financial statements.
Describe the anomaly of closed-end investment fund discounts.
Several studies have shown that closed-end funds tend to trade at a discount (sometimes exceeding 50%) to their per-share NAVs. Theoretically, investors could purchase all the shares in the fund, liquidate the fund, and make a profit by selling the constituent securities at their market prices.
Identify the implications of the efficient market hypotheses.
Securities markets are weak-form efficient. Therefore, past trends in prices cannot be used to earn superior risk-adjusted returns.
Securities markets are also semi-strong form efficient. Therefore, investors who analyze information should consider what information is already factored into a security’s price, and how any new information may affect its value.
Securities markets are not strong-form efficient. This is because insider trading is illegal.
