Topic 5 - Market Efficiency Flashcards
If markets are efficient, what should the correlation coefficient be between stock returns for two non-overlapping time periods?
The correlation coefficient should be zero. If it were not zero, then one could use returns from one period to predict returns in later periods and therefore earn abnormal profits.
Steady Growth Industries has never missed a dividend payment in its 94 – year history. Does this make it more attractive to you as a possible purchase for your stock portfolio?
No, it is not more attractive as a possible purchase. Any value associated with dividend predictability is already reflected in the stock price.
What are some possible investment implications of the behavioural critique?
An unfortunate consequence of behavioural finance is a tendency for investors to assume more than is actually claimed by the field. While behavioural finance is highly critical of EMH and claims to offer alternative theories, it does not propose to be a predictor of future returns. Investors should be wary of people purporting to offer excess returns under the façade of behavioural finance. Such claims are likely to be false.
Briefly explain the concept of the EMH and each of its three forms - weak, semi strong and strong- and briefly discuss the degree to which existing empirical evidence supports each of the three forms of the EMH.
The EMH states that a market is efficient if security prices immediately and fully reflect all available relevant information. If the market fully reflects information, the knowledge of that information would not allow an investor to profit from the information because share prices already incorporate the information.
The weak form of the EMH asserts that stock prices reflect all the information that can be derived by examining market trading data such as the history of past prices and trading volume. A strong body of evidence supports weak-form efficiency in the major US securities markets. For example, test results suggest that technical trading rules do not produce superior returns after adjusting for transaction costs and taxes.
The semi-strong form states that a firm’s stock price reflects all publicly available information about a firm’s prospects. Examples of publicly available information are company annual reports and investment advisory data. Evidence strongly supports the notion of semi-strong efficiency, but occasional studies (e.g. those identifying market anomalies such as the small-firm-in-January or book-to-market effects) and events (e.g. the market crash of 19 October 1987) are inconsistent with this form of market efficiency. However, there is a question concerning the extent to which these ‘anomalies’ result from data mining.
The strong form of the EMH holds that current market prices reflect all information (whether publicly available or privately held) that can be relevant to the valuation of the firm. Empirical evidence suggests that strong-form efficiency does not hold. If this form were correct, prices would fully reflect all information. Therefore even insiders could not earn excess returns. But the evidence is that corporate officers do have access to pertinent information long enough before public release to enable them to profit from trading on this information.
b. Briefly discuss the implications of the EMH for investment policy as it applies to: 1. Technical analysis in the form of charting 2. Fundamental analysis
b. i. Technical analysis involves the search for recurrent and predictable patterns in stock prices in order to enhance returns. The EMH implies that technical analysis is without value. If past prices contain no useful information for predicting future prices, there is no point in following any technical trading rule.
ii. Fundamental analysis uses earnings and dividend prospects of the firm, expectations of future interest rates and risk evaluation of the firm to determine proper share prices. The EMH predicts that most fundamental analysis is doomed to failure. According to semi strong-form efficiency, no
investor can earn excess returns from trading rules based on publicly available information. Only analysts with unique insight achieve superior returns.
In summary, the EMH holds that the market appears to adjust so quickly to information about both individual stocks and the economy as a whole that no technique of selecting a portfolio using either technical or fundamental analysis can consistently outperform a strategy of simply buying and holding a diversified portfolio of securities, such as those comprising the popular market indexes.
Briefly explain the roles or responsibilities of portfolio managers in an efficient market environment.
c. Portfolio managers have several roles and responsibilities even in perfectly efficient markets. The most important responsibility is to identify the risk/return objectives for a portfolio given the investor’s constraints. In an efficient market, portfolio managers are responsible for tailoring the portfolio to meet the investor’s needs, rather than to beat the market, which requires identifying the client’s return requirements and risk tolerance. Rational portfolio management also requires examining the investor’s constraints, including liquidity, time horizon, laws and regulations, taxes and unique preferences and circumstances such as age and employment.
