TOPIC 8 - MARKET EFFICIENCY Flashcards
What did Kendall (1953) find regarding stock price changes?
no predictable pattern –> prices as likely to go up down on any day –> random
what are the 2 predictions of the efficient market hypothesis?
1) security prices reflect whatever info is available to investors
2) active traders will find it difficult to outperform passive strategies like market indices (Investors buying securities in an efficient market should expect to obtain an equilibrium rate of return)
under behavioural finance are investors assumed to be rational?
no!
CAPM assumes only one thing when it comes to determining why dif securities offer dif expected rates of return
beta ( a measure of how an individual asset moves (on average) when the overall stock market increases or decreases.)
why is it nearly impossible to conduct a definitive test of CAPM?
bc it relies on an unobservable market portfolio
recent research suggests what about the return relationship
Risk-return relationship might entail multiple sources of systematic risk
under the EMH, stock prices should follow
a random walk
in terms of the EMH, what are random walks a consequence of?
intelligent investors competing to discover relevant information on which to buy or sell stocks before the rest of the market becomes aware of that information
higher investment returns motivates what?
information gathering (info the most precious financial commodity!)
weak form version of EMH
stock prices already reflect all info contianed in teh history of past prices
semi-strong form version of EMH
stock prirces already reflect all publicly available info
strong form version of EMH
stock prices reflect all relevant info, including insider info
technical analysis
Research to identify mispriced securities that focuses on recurrent and predictable stock price patterns and on proxies for buy or sell pressure in the market
Key to success from technical analysis
is a sluggish response of stock prices to fundamental supply-and-demand factors
EMH implies technical analysis should be fruitless
fundamental analysis
Assessment of firm value that focuses on such determinants as earnings and dividends prospects, expectations for future interest rates, and risk evaluation
fundamental analysis seeks to
find firms that are mispriced
EMH predicts that most fundamental analysis is dommed to failure
active vs passive management
• Active Management
An expensive strategy
Suitable for very large portfolios
• Passive Management No attempt to outsmart the market Accept EMH Index Funds and ETFs Low cost strategy
even if markets are efficient what’s the role of portfolio management?
a) diversification
b) tax considerations
c) risk profile of investor
3 issues affecting markets and their efficiency
1) magnitude issue
2) selection bias issue
(only unsuccessful/partially successful investment schemes made public)
3) lucky event issue (for every winner there are big losers, we just don’t hear it as not publicised much)
1) magnitude issue
(only large portfolio managers can earn enough trading profit to exploit minor mispricing)
2) selection bias issue
(only unsuccessful/partially successful investment schemes made public)
3) lucky event issue
(for every winner there are big losers, we just don’t hear it as not publicised much)
acute market inefficiencies like a temporary drop in a stock price due to a large sale is more or less easily exploited than chronic inefficiencies
more easily exploited!
for weak form EMH what are returns like over short term?
tendency of poorly performing stocks and well-performing stocks in one period to continue that abnormal performance in following periods (moment effect)
for weak form EMH what are returns like over long-term?
reversal effect is the tendency of poorly performing stocks and well performing stocks in 1 period to experience reversals in following periods
Fama and French say what about returns on the stock market and dividends
return on stock market tends to be higher when dividend yields are higher
Campbell and Shiller say what about predicting stock market returns
earnings yield can predict market returns
Keim and Stambaugh say what about bond spreads and the market
bond spreads can help predict broad market returns
price drift and post earnings announcements in sem-strong markets
there’s a sluggish response of stock prices to firms’ earnings announcements –> market adjusts earnings info gradually –> results in sustained periods of abnormal returns
semi-strong tests
1) post earnings-announcement price drift
2) P/E effect
3) Neglected firm effect
4) liquidity effect
semi-strong test - P/E effect
portfolios of low P/E ratio stocks have provided higher returns that high P/E portfolios
semi-strong test - neglected firm effect
investments in stocks of less well known firms have generated abnormal returns
semi-strong test - illiquid effect
illiquid stocks have strong tendency to exhibit abnormally high returns
interpreting market anomalies - what do Fama and French say?
these effects can be explained by risks premiums
Feature that small firms, low market-to-book firms, and recent “losers” seem to have in common is
a stock price that has fallen considerably in recent months/years
interpreting market anomalies - what do Lakonishok, Shleifer, and Vishny say?
argue that these effects are evidence of inefficient markets
performance on factor portfolios are shown to correlate with
state of the business cycle (previous years economic growth) suggests these factors (style and size factors) from Fama and French are capturing a source of systematic risk –> market wide influence
in well functioning markets, over time anomalies should
self-destruct over time
liquidity and low trading costs facilitate
efficient price deiscovery
when do bubbles occur?
when a rapid run-up in prices creates a widespread expectation that they will continue to rise
what do stock market analysts have a tendency to do?
be overwhelmingly positive in the assessment of the prospects of firms
mutual fund performance
Some active managers outperform, some underperform but on average level of outperform not that dif from 0
what does conventional finance say?
prices are correct and = to intrinsic value, resources allocated efficiently
behavioural finance
investors may not be rational –> arbitragerus are limited and thus insufficient to force prices to match intrinsic value
2 aspects of the behavioural critique
- Investors don’t always process info correctly and thus infer incorrect probability distributions of future returns
- Even when given a probability distribution of returns, investors may make inconsistent or suboptimal decisions
4 types of behavioural biases
1) framing
2) mental accounting
3) regret avoidance
4) affect and feelings
framing - behavioural bias
Decisions affected by how choices are described, such as whether uncertainty is posed as potential gains from a low baseline level, or as losses from a higher baseline value
mental accounting - behavioural bias
Specific form of framing in which people segregate certain decisions
humans place different values on money, which leads to irrational decision making.
when people put their money into separate mental categories, separating them into different mental accounts, based on, say, the source of the money, or the intent of the account.
regret avoidance - behavioural bias
Individuals who make decisions that turn out badly have more regret when that decision was more unconventional
affect and feelings - behavioural bias
Investors tend to choose stocks with high affect, driving up prices while simultaneously driving down returns
behavioural view prospect theory vs conventional view
behavioural view: utility depends on changes in wealth from current levels, not the level of wealth
conventional view: higher wealth provides higher utility but at a diminishing rate
behavioural view prospect theory (which is consistent with risk averse behaviour)
people think in terms of expected utility relative to a reference point (e.g. current wealth) rather than absolute outcomes.
3 things that limit arbitrage
1) fundamental risk - intrinsic value and market value may take too long to converge
2) implementation costs - transaction costs can take too long and restrictions on short selling, limiting arbitrage activity
3) model risk- ur model could just be shit and market value actually correct
dividend discount model
=expected dividend /(cost of equity - growth rate)
provides a rational explanation for stock market bubble using this model
market bubbles are inconsistent with
rational pricing, intrinsic value in the securities, and market efficiency
expected return beta relationship
E(ri) = rf + B[E(rm)-rf)
B= Cov(ri,rm)/Vm
what is the security characteristic line
is a regression line, plotting performance of a particular security or portfolio against that of the market
first pass regression and the SCL for tests of the E(r) beta relationship
time series regression to estimate betas of securities/portfolios
second pass regression and the SCL for tests of the E(r) beta relationship
cross-sectional regression of portfolio excess returns on betas, where estimated slope is the measurement of the reward for bearing systematic risk during the period
If beta is measured with error and appears as a right-hand-side variable in the second-pass regression:
Slope coefficient of the regression equation will be
biased downward Intercept biased upward
In terms of CAPM tests Fama and MacBeth verify the following:
1) Observed relationship between average excess returns and beta is indeed linear
2) Non-systematic risk does not explain average excess returns
• Liquidity involves the following 5 things
1) Trading costs
2) Ease of sale
3) Necessary price concessions to effect a quick transaction
4) Market depth
5) Price predictability
what does technical analysis focus on?
stock price patterns and on proxies for buy or sell pressure in the market.
fundamental analysis looks at
the determinants of the underlying value of the firm, ie, current profitability and growth prospects
Empirical studies of technical analysis don’t generally support the hypothesis that
such analysis can generate superior trading profits. One notable exception to this conclusion is the apparent success of momentum based strategies over intermediate term horizons
what does behavioural finance focus on?
systematic irrationalities that characterise investor decision making. These “behavioural shortcomings” may be consistent with several efficient market anomalies.
Limits to arbitrage activity impede the ability of rational investors
to exploit pricing errors induced by behavioural investors.
Technical analysis is the search for
technical analysis is based on
recurring and predictable patterns in stock prices. It is based on the premise that prices only gradually close in on intrinsic value. As fundamental shifts, astute traders can exploit the adjustment to a new equilibrium.
what indicators does fundamental analysis use?
volume data and sentiment indicators,
Early tests of the single-factor CAPM rejected
the SML finding that non-systematic risk was related to average security returns.
Later tests of the single-factor CPAM controlling for the measurement error in beta found that non-systematic risk
doesn’t explain the portfolio returns but also that the estimated SML is too flat compared with what the CAPM would predict.
Roll’s critique implies that the usual CAPM test is a test only of
the mean-variance efficiency of a prespecified market proxy and thus that tests of the linearity of the expected return-beta relationship do not bear on the validity of the model.
Tests of the single-index model that account for human capital and cyclical variations in asset betas are more or less supportive of the single-index CAPM and APT
more supportive.
Moreover, anomalies such as the size and book-to-market effects are mitigated once these variables are accounted for.
The equity premium puzzle originates from the observation that equity returns exceeded the risk-free rate to an extent that is
inconsistent with the covariance of returns with consumption risk and reasonable levels of risk aversion at least when average rates of return are taken to represent expectations.
Investors are slow to update their beliefs when given new evidence –> what behavioural effect is this
conservatism bias
Investors are reluctant to bear losses caused by their
unconventional decisions.
Regret avoidance
Investors exhibit less risk tolerance in their retirement accounts versus their other stock accounts.
mental accounting
Investors are reluctant to sell stocks with “paper” losses.
Disposition effect
investors disregard sample size when forming views about the future from the past.
representativeness bias
illusion of knowledge in behavioural finance
if u believe you’re an expert on and can make accurate forecasts about something based on own research –> might not understand how to analyse the info nor have the ability to apply it to a proposed investment
overconfidence in behavioural finance causes us to
misinterpret the accuracy of our info and our skill in analysing it. IF u assume info you have is accurate w.o trying to verify it/consult other resources, plus u may assume overconfidence in ability to evaluate/analyse the info
reference points in behavioural finance
fixation on a reference point and waiting for price of a security to move above that reference point before selling it eg, could prevent investor from undertaking a risk/return-based analysis of portfolio position
familiarity in behavioural finance
Irrational investors believe an investment in a company with which they are familiar will produce higher returns and have less risk than unfamiliar investments
(where you evaluate holding in a stock based on familiarity with the company rather than sound investment and portfolio principles. Company employees eg could have distorted view of the company)
representativeness in behavioural finance
confusing company (which may well be a good company) with the company’s stock (which may or may not be an appropriate holding for his portfolio and/or a good investment) and its future performance. This can result in employees overweighting their company stock, thereby holding an under-diversified portfolio.
