Reading 47 LOS's Flashcards
LOS 47a: describe market efficiency and related concepts, including their importance to investment practioners
An informationally efficient market is one where security prices adjust repidly to reflect any new information. It is a market where asset prices reflect all past and present information
Investment managers and analysts are interest in market efficiency because it dictates how many profitable trading opportunities may be abound in the market
- In an efficient market, it is difficult to find inaccurately priced securities. Therefore superiod risk-adjusted returns cannot be attained in an efficient market and it would be better to pursue a passive investment strategy
- In an inefficient market, securities may be mispriced and trading in these securities can offer positive reisk-adjusted returns. In such a market, an active investment stratgey may out perform a passive
Efficient markets securities reflect price changes based on new information quickly where as inefficient doesnt.
Efficient markets, prices only adjust to new or unexpected information, whereas inefficient can change due to insider info
LOS 47b: Distinguish between market value and intrinsic value
The market value or price of the asset is the price at which the asset can currently be bought or sold. it is determined by the interaction of supply and demand for the security
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 the available information regarding the asset, they are not know for certain
In an efficient market, participants believe market price and intrinsic value are the same, whereas in inefficient markets, investors will develop their own intrinsic values on securities and try to take advantage of underpriced
LOs 47c: Explain factors that affect a market’s efficiency
Market participants the greater number of participants that analyze an asset or security, the greater the degree of efficiency in the market. Restrictions that prevent parcitipants from trading impede market efficiency
Information availability and financial disclosure The availability of accurate and timely information regarding trading activities and traded companies contributes to market efficiency
_Limits to trading_The activities of arbitrageurs contribute to market efficiency. They buy undervalued securities and short overvalued. Restrictions on arbitrage trading reduces market efficiency
Transaction costs and information-acquisition costs Investors should consider transaction costs and information-acquisition costs in evaluating the efficiency of a market
LOs 47d: Contrast weak-form, semi-strong, and strong-form market efficiency
Weak-Form Efficient Market Hypothesis
This assumes that current stock prices reflect all security market information, including historical trends in prices, returns, volumes, and other market-generated information such as block trades and trading by specialists
Proponents of weak-form EMH assert that abnormal risk-adjusted returns cannot be earned by using trading rules and technical analysis, which make investing decisions based on historical security market data
Semi-Strong Form EMH
This form assumes that current security prices fully reflect all security market information and other public information. It encompasses weak-form and also includes nonmarket public information such as dividend announcements, various financial ratios, and economic and political news.
Proponents of the hypothesis assert that investors cannot earn abnormal risk-adjusted returns if their investment decisions are based on important material information after it has been made public. They stress that security prices rapidly adjust to reflect all public info.
Strong-From EMH
This form contends that stock prices reflect all public and private information. It implies that no group of investors has sole access to any information that is relevant in price formation
Strong form EHM encompasses weak-form and semi-strong from EMH and assumes perfect markets where information is cost free and available to all. Under strong-form EMH, no on can consistenyl achieve abnormal risk-adjusted returns, not even company insiders.
LOS 47e: Explain the implications of each form of market efficiency for fundamental analysis, technical analysis, and the choice between active and passive portfolio management
Efficient Markets and Technical Analysis
If the market is weak-form efficient, prices reflect all available security market public info, and technical trading systems that depend only on past trading and price data cannot hold much value. Since tests have predominatly confirmed weak-form efficiency of markets, technical trading rules should not generate abnormal risk-adjusted profits after accounting for risks and transaction costs
Efficient Markets and Fundamental Analaysis
Fundamental analysts are concerned with the company that underlies the stock so they evalate a company’s past performnce and examine its financial statements. Fundamental analysis is necessary in a well-functioning securities market, as it helps market participants understand the implications of any new information. Further, fundamental analysis can help generate abnormal risk-adjusted returns if the analysts is superior to their peers. Fundamental analysts can make a profit in weak-form, but not semi-strong or strong, since those forms believe securites prices reflect both historical and financial statement data
Efficient Markets and Portfolio Management
If the markets semi-strong form efficient, active management is not likely to earn superior risk-adjusted returns, so passive management is preferred. The implication here is that the role of portfolio manager is not necessarily to beat the market, but to manage the portfolio in light on the investor’s risk and return objectives
LOS 47f: Describe selected market anomalies
1)Time Series Anomalies
Calendar Anomalies
January effect Studies have shown that since the 1980s, investors have earned significantly higher returns in the equity market during January compared to other months of the year. Tax reasons and “window-dressing” by portfolio managers have been held out as reasons to explain the effect.
Turn of the Month returns are higher on last day of month and first three trading days of next months
Day of the week effect average monday returns are negative, whereas the rest are positive
Weekend effect returns on weekends tend to be lower than returns on weekdays
Holiday effect returns on stocks in the day prior to market holidays tend to be higher than other days
Momentum And Overreaction Anomalies
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 compannies that have released good news. Studies have shown that stocks that have witnessed a recent price decline due to bad news have outperformed the market in subsequent periods, while winners have underperformed.
These anomalies go against the assertions of weak-form EMH
2) Cross-sectional Anomalies
Size effect
Studies conducted in the past showed that shares of smaller companies outperformed shares of larger companies on a risk-adjusted basis. Recent studies have failed to meet this conclusion
Value Effect
Studies have found that low P/E stocks have experienced higher-risk adjusted returns than high P/E stocks.
3) Other anomalies
Closed-End Investment Fund Discounts
Several studies have shown that closed-end funds tend to trade at a discount to their NAV. Theoretically, investors could purchase all the shares in the fund, liquidate the fund, and make a profit by selling the securities at their market price. However after accounting for costs, any profit potential is eliminated
Earnings surprises
Several studies have shown that although earnings surprises are quickly reflected in stock prices most of the time, this is not always the case
Initial Public Offerings (IPOs)
Evidence suggests that investors who are able to acquire the shares of a company in an IPO at the offer price may be able to earn abnormal profits
Implications for Investment strategies
Although there is some evidence to support the existence of valid anomalies, it is difficult to consistently earn abnormal returns by trading on them
LOS 47g: Contrast the behavioral finance view of investor behavior to that of traditional finance
Behavioral finance is a field of study that examines investor behavior and evaluates the impact of investor behavior on financial markets. The conclusions are as follows:
- Behavioralists assert that the dislike for risk is not symmetrical by pointing to loss aversion observed in investor behavior
- Another bias point out by behavioralists is overconfidence bias ( investors have an inflated view of their ability to process new info appropriately) SInce the bias asserts that most investors are incorrect in valuing securities given new info, stocks will be mispriced
- Other behavioral biases that have been put forward include:
- representativeness, where investors assess probabilities of future outcomes based on how similar they are to the current state
- Gamblers fallacy, where investors estimates of future probabilities are affected by recent outcomes
- Mental accounting, where investors keep track of gains and losses from different investments
- Conservatism, where investors are slow to react to changes
- Disposition effect, where investors are quick to sell gains, but avoid realizing losses.
Concluding remarks
Whether investor behavior can explain market anomalies is a subject open to debate
- If investors must be rational for the market to be efficient, then markets cannot be efficient
- If markets are defined as being efficient, investors cannot earn superior risk-adjusted profits consistently, available evidence suggests that markets are efficient even though investors do exhibit irrational behavior, such as herding
