Topic 12 Asset Market Efficiency and Behavioural Finance Flashcards
What is the principle underlying behavioural finance?
- Behavioural finance is saying investors are irrational and makes all kinds of mistakes makes opportunities for smart investors
How do asset prices change based on information?
- Prices respond to changes in expectations
- Changes in expectations arise from new information
- Therefore, asset prices change as new information arrives
What is the efficient market hypothesis?
‘In an efficient market, security prices fully reflect all available information.’
What does informational efficiency depend on?
a. The type of information is reflected
b. The speed with which new information is reflected - Market rationality
What are the consequences of trading on the basis of information?
a. The first investors to trade make a profit
b. The trading process causes security prices to reflect the information uncovered by market participants
What are the types of information?
- Historical
- Publicly available information
- Private information
What is historical data?
Trading data such as past prices and volumes. People will use the past data to forecast future movement
What is publicly available information?
- Financial statements, announcements, news
- Eg. quarterly reports, annual reports
- These news such as journals, or articles not from the company
What is private information?
- Inside information known to company management but not yet made public
- People who work inside the company are not allowed to trade with this information
o e.g. research data, takeover bid, UNEXPECTED earnings - Private assessment of public information
o e.g. analyst reports firm specific information
Why are we interested in market efficiency?
If market prices reflect only information of a particular type, then we can profit from trading on information not yet reflected in prices. We want to know to what degree the market is efficient to evaluate our trading strategy
What is weak form efficiency?
Prices reflect all information contained in the record of past prices and volumes
What’s the process of changes in price mvoement from access to new information?
a. Traders might have access to new information, and begin to reveal that information by the effect on prices
b. Perceiving a price trend, other market participants may transact in an attempt to profit from the new information
c. This speeds up the impounding of the information revealed by the initial price movement subsequent movements after the initial information has been impounded will be random
What is technical analysis?
Analysing past prices and volumes to predict future prices. Technical analysis involves using charts of a security’s historical prices or levels to forecast its future trends
Why is technical analysis not the best method?
‘Tomorrow’s prices should be independent of today’s prices’
If a market is weak form efficient, technical analysis is not profitable.
It should not be possible to make consistent profits from trading rules set up to detect and trade on the basis of price trends
What is the filter rule?
A commonly used trading rule is a filter rule, where the ‘filter’ represents a set percentage by which a stock must rise or fall in order to trigger a ‘buy’ or ‘sell’ signal, respectively
a. Buy if the stock rises X% from its previous lowest price
b. Sell if the stock falls X% from its previous highest price
What is the logic behind the filter rule?
The assumption behind this trading rule is that the trend identified will continue. Future price movements can be inferred from past prices.
What is semi-strong form efficiency?
Prices fully reflect all publicly available information
What are some features of semi-strong form efficiency?
a. A semi strong form efficient market must also be weak form efficient because historic prices and volumes are publicly available information.
b. Asset prices react immediately to the release of any new information that is made public
What is fundamental analysis?
Fundamental analysis: a practice of using financial statements, announcements and other publicly available information about firms to pick stocks.
What is an example of when semi-strong form efficiency is valid?
An Example: Suppose ABC’s stock only jumps to $104:
* A price of $104 does not accurately reflect all the available information.
* We can make trading profits by buying ABC at $104 and holding until
a. The market realizes we are right, or
b. ABC pays out (in dividends or stock buybacks) the value of the research success.
* Buying at the open at $104 you can profit an abnormal return when it will have a fair value of $110
* Either you buy at the fair value or the market is not efficient and you can buy below the fair value
What is strong form efficiency?
All available information is fully reflected in current prices
What are some features of strong form efficiency?
a. A strong form efficient market must also be semi strong and weak form efficient because publicly available information as well as historic prices and volumes are a subset of all available information
b. Asset prices should reflect private information (private assessment of public info and inside info)
What is an example of strong form efficiency?
- Stock ABC Biotech’ s closing price yesterday $100.
- You work for a stock brokerage company and received a large buy order for ABC’s stocks from a client (a fund) with private information.
- You learned that ABC has got better than expected trial results (extra value=$10 per share).
- You begin to buy ABC’s stock at $100 (house trading to maximise your own profits) prices keep going up as you buy.
- You stop buying when price reaches $110, reflecting private information.
What are tests of market efficiency?
a. Are trading rules using past prices profitable? –> to test weak form: if you can make profit, then it’s not weak form
b. Do prices react rapidly to information around particular events? –> to test semi strong form
c. Is it possible for investors to profit from private information? –> strong form, if it does work then it violates strong form efficiency
d. Can active fund managers outperform their benchmarks?–> if they have access to private assessment and public information, if they can generate abnormal returns it violates strong form efficiency
What is a test of weak form efficiency?
Generally speaking, academic research finds that it is not possible to make systematic profits from trading rules relying on price patterns in Australia, implying that the ASX is weak form efficient.
More recent studies in other markets have reported that no useful information can be obtained from past prices (Asian markets, China, and other emerging markets).
What are tests of semi-strong efficiency?
The most common test of semi strong form efficiency is an event study which examines the behaviour of prices around information events or announcements
* The purpose of these studies are to analyse how quickly new information is reflected in share prices and the returns possible for an investor
* A large number of academic studies find that the equity market in the United States is semi strong form efficient public reacts strongly to public news
How do you calculate abnormal returns?
ARt = rt - E(rt)
ARt = abnormal return in the time interval t
rt = actual return in the time interval t
E(rt) = expected return in the time interval t
What is an event study?
A research methodology designed to measure the impact of an event of interest on stock prices after the event date
How do you calculate average abnormal returns (measure the imapct of an event on stock prices)?
a. Define as day ‘zero’ the day the information is released (event day)
b. Define abnormal return as the difference ARit = Rit – E(Rit)
c. Calculate ARit T days around ‘zero’: t = -T, -(T-1),…, -1, 0, 1,…., T-1, T
d. Calculate average abnormal returns (AAR) over all N events in the sample for all references days between [-T, T]
e. Calculate the cumulative average abnormal returns (CAAR)
What is the test for semi-strong form efficiency?
This methodology is easy to apply, and has been used to study a large number of events
a. Dividend changes
b. Earnings
c. Mergers
d. Capital expenditures
e. New issue of stock, or new issues of debt
f. Changes in stock exchange listing
g. Stock buybacks
Almost all the evidence indicates that the market is semi-strong form efficient.
What isthe test for strong-form efficiency?
If a market is strong form efficient all available information is fully reflected in current prices. Therefore, it should not be possible to profit from “insider trading”
If a market is strong form efficient it is impossible to consistently outperform the market due to the fact that all information is already reflected in current asset prices and, therefore, it is impossible to earn long term abnormal returns.
How does EMH support passive investing approach?
EMH supports the passive investing approach: investors should hold a well diversified market portfolio based on the portfolio and CAPM theory
What are index funds?
Index funds are passively managed funds that track and invest in a particular benchmark index.
Why is an inefficient market bad?
- Some people might think inefficient is better as people can get information and use that to get abnormal profits
- In an inefficient market however you cannot determine if a price is fair
- Benefit of efficient market is that you do not need to perform a lot of research to determine if a price is fair, just making sure you diversify your portfolio and buying a few index funds
What is the evidence against EMH?
a. Market anomalies
b. Behavioural Finance
What are market anomalies?
A market anomaly is a price action that contradicts the expected behaviour of the stock market.
What are some features of market anomalies?
- The existence of these anomalies is contrary to the Efficient Markets Hypothesis. These studies are based on repeated patterns or behaviour in stock price movements.
- Anomalies allow the prediction of future returns using these known patterns
- Prices may not reflect value
What are some types of market anomalies?
- Day of the week effect
- January effect
- Size effect
- Book to market effect
- Momentum effect
What is the day of the week effect?
returns on Mondays are often lower than other days of the same week
What is the january effect?
higher stock prices in January than other months of the year
What is the size effect?
buy small stocks and sell large stocks
What is the book to market effect?
Buy stocks with small B/M ratio and sell stocks with large B/M ratio
Compares the book value of the company to the price of the stock. Less than 1 implies that a company can be bought for less than the value of its assets. A higher figure of around 3 would suggest that investing in a company would be expensive
What is the momentum effect?
Buy ‘winner’ stocks and sell ‘loser’ stocks of the previous period can generate trading profit
* Tendency of stocks that performed well in the past to continue to do well in the following period and vice versa for stocks with a poor performance
* Both over and underreaction to news may explain the momentum effect
What is behavioural finance?
Investors do not always process information correctly or may make inconsistent or sub optimal decisions This results in market prices that differ from fundamental values
What are some types of behavioural finance conepts?
- Overconfidence bias
- Herding tendency
What is overconfidence bias?
Overconfidence bias: overconfident investors may overestimate their abilities to identify successful investments and tend to underperform in trading
What is herding tendency?
- Herding tendency that investors like to follow others resulting in market bubbles eg. tech bubble and housing bubble
What are some efficient market concepts?
- Markets and investors are perfectly rational
- Investors always seek to maximize their utility
- Investors have perfect self control
- Investors are never confused in their decision taking by cognitive errors
What are some behavioural finance concepts?
- Markets and investors are normal, not rational
- Investors are risk-averse
- Investors have limits to their self-control due to individual biases
- Investors often experience cognitive errors which may contribute to wrong decisions
