Market Efficiency

Outline
1. Definition and properties of efficient markets
2. Forms of market efficiency
3. Anomalies
4. Fundamental versus technical analysis
5. Bubbles and crashes
6. Behavioral finance

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 1. Concept and definition
• A market is efficient if the price of securities reflect their real
value (fundamental, intrinsic value)

• The whole set of information relevant for financial asset

valuation is instantaneously reflected in prices

• Incorporation of the information in prices: the new information

changes the stock price

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 1. Concept and definition
• In an efficient market, given the information available at the time
of the investment, an investor cannot consistently obtain an
expected return above the one required for the incurred risk

• In other words, in an efficient market prices reflect fundamental

values, therefore the NPV of each investment is equal to 0

• A market is efficient if it is impossible to make abnormal profits

(other than by chance) by using the set of information available
to make trading decisions

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 1. Concept and definition
Given a set of information, a market is efficient if that information
cannot be used to obtain:
• “Abnormal profits”: Excess returns over the expected return, as
given by the appropriate equilibrium model (such as the CAPM),
and net of transaction costs.
• “Other than by chance”: Sometimes, by luck, but not in a
systematic manner.

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 1. Concept and definition
• Price reaction to new information
• Reaction on an efficient
market: the price adjusts
instantaneously and reflects
all the information, no
further increases or
decreases thereafter

• Slow response: the price

adjusts slowly: it takes 30
days for the information to
be completely reflected in
the price

•Overreaction: the price

more than adjusts, a bubble
is formed
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Source: Ross et all, 2005
 1. Concept and definition
Properties of efficient markets
• Many rational investors, who maximize their profits and actively
participate in the market, analyzing, valuing and trading assets
• A competitive market: no investor can significantly affect the
price of an asset with her individual trade
• Information is available for free for all investors at the same time
• New information arrives randomly, and is unpredictable by
definition, therefore news are not related across time
• Expectations only change when new information arises and
arrives at the market
• Investors react rapidly to new information that will be reflected in
the prices
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 2. Forms of market efficiency
• Depending on the type of information reflected in prices, we can
define three types of market efficiency:

– Weak form of efficiency: past prices

– Semistrong form of efficiency: public information
– Strong form of efficiency: private information

• This typology was established by Fama (1970)

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 2. Forms of market efficiency
Weak efficiency
• The market completely reflects the information contained in
past prices

• Past prices cannot be used to predict the evolution of future

prices

• It questions the relevance of technical analysis

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 2. Forms of market efficiency
Weak efficiency

• There are no patterns in prices

• If patterns existed in the prices, people would identify them and

exploit them, which would lead to their disappearance

• Empirical studies seem to confirm weak efficiency

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 2. Forms of market efficiency
Weak efficiency
• Investors’ behavior tend to eliminate cyclical regularities

Source: Ross et al, 2005 11

 2. Forms of market efficiency
Semistrong efficiency
• Prices reflect all public information: published financial
statements, annual reports, announcement to the press

• All publicly available information is immediately

incorporated in prices:
– Announcement of results
– Announcement of share issues
– Announcement of takeover bids

• Most empirical studies confirm the semistrong form of

efficiency, although there are anomalies
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 2. Forms of market efficiency
Strong efficiency
• The market reflects all the information, either public or
private, actual or past

• Privileged information of which insiders benefit are

incorporated in prices as soon as the trading based on this
information takes place

• Empirical studies are rather contrary to this version of the

efficiency

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 2. Forms of market efficiency
• Relationship between the 3 forms of efficiency

All relevant information

Public information

Past
prices

The strong form implies the semistrong form and the 14

semistrong form implies the weak form
 2. Forms of market efficiency
Empirical studies

• Weak efficiency: tests to predict the return

• Semistrong efficiency:
– Event studies
– The performance of mutual funds

• Strong efficiency: tests of private information

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 2. Forms of market efficiency
Empirical studies – weak
efficiency:
- Return autocorrelation

– Indicated point:
+x% followed by –x%
– A tendency for increases
to be systematically followed
by decreases would imply:
-many SE points
-few NE points
- Lack of pattern
Source: Brealey et al, 2006 16
 2. Forms of market efficiency
– Many people think that they see patterns even where they
don’t exist

A. Simulated price changes- B. Real price changes of the

random walk share The Gap

Source: Ross et al, 2005

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 2. Forms of market efficiency
Empirical studies – semistrong efficiency
Event studies: Takeover bid announcement

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Source: Brealey et al, 2006
 2. Forms of market efficiency
Empirical studies – semistrong efficiency
• Favorable evidence for semistrong efficiency:
– The announcement day the price jumps up suddenly
– The adjustment is immediate
– No evolution the following days
• Remark: the price in the days before the announcement
already had an upward trend:
– There is a gradual leak of information about a possible
takeover
• In general, the adjustment of a price after an
announcement about the results or the dividends takes
place in the 5-10 minutes following the announcement
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 2. Forms of market efficiency
Empirical studies – semistrong efficiency: Fund performance

- Below the market half of the years Source: Brealey et al, 2006 20
 2. Forms of market efficiency

Empirical studies – strong efficiency

• Focus on insiders’ operations

• Several studies show that transactions made by insiders on

the shares of their companies have generated abnormal
returns

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 3. Anomalies
• Financial markets seem to behave efficiently with respect to
publicly available information

• However, sometimes the empirical evidence seems to be

inconsistent with the efficient market hypothesis

• These distortions in the prices or returns are called

anomalies

• They are related with:

– The size effect
– The market value vs book value effect
– The calendar effect
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 3. Anomalies
The size effect
– The return on stocks of small capitalization seem to
be larger than those of large capitalization

The market to book ratio effect

– Firms with higher book-to-market ratios seems to
have a higher return than those with lower book-to-
market ratios

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 3. Anomalies
• Calendar anomalies
– The weekend (Monday) effect (-)

– The January effect (+)

– The mid-day swoon: stocks on average tend to have

a higher price at the opening, then they reach the
lower point around mid-day, and increase again
towards the closing of the market

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 3. Anomalies
• Calendar anomalies: The weekend (Monday) effect

Dow Jones average daily returns (%),

1885-1997
0.1
0.05
0
-0.05
-0.1
-0.15

Source: Siegel, 1998

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 3. Anomalies
Announcement of results

Source: Ross et al, 2005 26

 3. Anomalies
New share issues and IPOs

• The annual returns of issuing firms for the 5 years following

the IPO are 2% lower than those of similar firms that haven’t
gotten listed

• The annual returns of listed firms that issue new shares are 3
to 4% lower to those of similar firms that haven’t issued
shares

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 3. Anomalies
New share issues and IPOs

Source: Ross et al, 2005 28

 3. Anomalies
• These anomalies do not occur consistently so as to be able
to make reliable abnormal returns

• Interestingly, the anomalies seem to disappear or invert after

being documented in the literature

• This might be because of two reasons:

– It was just a coincidence that appeared as a result of the
effort of researchers to find interesting patterns in the
data, so that in reality the anomaly never existed

– It reflects the actions of professional investors who have

exploited the anomaly leading to the disappearance of
investment strategies with abnormal returns
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 3. Anomalies
• So are markets efficient?

• According to Burton Malkiel markets are efficient on the

long-term, the market will correct any inefficiency on the
long-term

• However, there is enough empirical evidence to justify the

search of undervalued securities

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 3. Anomalies
Financial strategies
• The key to choose a strategy is the way we regard the stock
market:

• Is the stock market efficient?

• YES → Track the market

• NO → Try to “beat” the market

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 3. Anomalies
Financial strategies:

Passive strategy

• Goal: Obtain the same earnings as the stock market

• Strategy: Portfolio that replicates the stock market index

Active strategy
• Goal: Obtain higher earnings than the stock market, taking
profit from its inefficiencies
• Strategy: Portfolio that deviates from the stock market index

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4. Fundamental vs technical analysis
• There are two ways to “predict” sock prices usually
used by financial analysts:

– Fundamental analysis (or analysis of intrinsic value)

– Technical analysis

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4. Fundamental vs technical analysis
Fundamental analysis

• Seeks to determine the proper stock price or intrinsic stock

value analyzing:
– several balance sheet variables (earnings, dividends, …) in
both their past records and future prospects

– expectations on the evolution of macroeconomic variables

(interest rates, exchange rates, prospects for the
economic or industrial sector where the firm is acting, …)

– risk evaluation of the firm (quality of management,

standing within its industry, …)

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4. Fundamental vs technical analysis
Fundamental analysis

• It is much more difficult than the simple fact of identifying

well managed firms with good perspectives
– Finding good firms does not bring anything to the investor
by itself if the rest of the market also knows that those
companies are good

– The trick is not to find good companies, but finding those

that are better than what the estimations of the other
seem to indicate

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4. Fundamental vs technical analysis
Technical analysis

• Consists of searching for predictable patterns in stock prices

• Technicians try to identify trends in past prices that help

them to predict future price changes

• Technical analysts are also called chartists because they

study records of past prices that they translate into charts,
which they interpret trying to find patterns that they can
exploit to make a profit

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4. Fundamental vs technical analysis
Technical analysis
• It does not try to find out if a stock is properly valued, it just
tries to find the best moment to buy or to sell

• It does not deny fundamental analysis, but it claims that

irrespective of the fundamental reason behind a price
change, if the price responds sufficiently slowly, the analyst
will be able to identify a tendency which can be exploited
during the adjustment period

• Therefore, the key of a successful technical analyst is a slow

response of stock prices to fundamental factors

• This conditions is completely opposed to the notion of an

efficient market
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4. Fundamental vs technical analysis
Technical analysis

• It basically consists of searching recurrent and predictable

patterns in stock prices

• If there exists a pattern in stock prices that investors can

exploit, many investors will try to take advantage of it,
which will finally move prices and self-destruct the
investment strategy

• Although ex post it is easy to identify an upward tendency

in historical prices, recognizing price patterns while they
appear is much more difficult

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 5. Bubbles and crashes
• Bubble= disproportionate and systematic increase in
asset prices not justified by objective facts

i.e. prices increase but value does not increase, without

the market being aware of that

Most famous bubbles:

• The Tulip-Bulb Craze
• The South Sea Bubble
• The U.S. stock market bubble and Crash, 1928-1932
• The internet bubble
• The real estate bubble of 2007
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 5. Bubbles and crashes
The birth of a bubble
• Historically, bubbles are related to new technologies or new
trading opportunities

• Investors become fascinated by a new business opportunity

or a new technology: they regard it as a permanent source
of value creation

• Investors think that the price of an asset will always rise and
never fall (real estate)

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 5. Bubbles and crashes
Growth
• Investors buy the stocks that are fashionable, therefore
their prices start growing up and investors earn money

• An amplification feedback loop gets formed: investors buy

more assets to earn more money

• New investors enter the market

• The optimism spreads to all stocks, the whole market goes

up and investors buy more and more assets

• The prices of today are higher than yesterday’s prices

simply because yesterday’s prices were higher than the
prices of the day before yesterday: Irrational exhuberance41
(Alan Greenspan)
 5. Bubbles and crashes
Critical phase
• Some investors start having doubts about the ratio price to
value, and become afraid of a possible crisis

• Price volatility increases and confidence falters

Bubble burst
• Some investors realize that prices are too high with respect
to value, and start selling the respective assets, which causes
a sudden fall in their price: panic spreads

• Massive sales begin: the feedback loop goes in reverse-

downward feedback loop

• The burst of a financial crisis can lead to an economic crisis

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 5. Bubbles and crashes
• The evolution of the CAC 40 (France)

Historical high Real estate bubble- subprime crisis

cc

Internet bubble burst

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Source: www.economie.gouv.fr
 6. Behavioral finance
• Since the 1990s several studies have reported on financial
market phenomena that contradict the efficient market
hypothesis

• For many financial analysts and researchers models based

on perfect rationality of investors were proving to be
incapable of explaining these observations satisfactorily

• A new field in Finance was born: Behavioural Finance

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 6. Behavioral finance
• It attempts to fill this void using psychology-based theories
to explain stock market anomalies

• It studies the effects of psychological, social, cognitive, and

emotional factors on:
– the decision making processes of individuals and
institutions
– the consequences for market prices, asset returns and
resource allocation by investors

• Assumes that all the available information is not correctly

used

• Questions the investor rationality hypothesis

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 6. Behavioral finance
• Efficient markets theory:
– investors are fully rational

• Behavioural finance:
– investors are not fully rational
+there are substantial barriers to arbitrage

• If a perfect arbitrage is possible, lacks of rational

behaviour that separate price from value do not matter
because arbitrage equates again price and value

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 6. Behavioral finance

• But we cannot rely on arbitrage to bring prices in line

with fundamental values because there are limits to
arbitrage

• Thus prices are not efficient

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 6. Behavioral finance
Limits to arbitrage
• Ex: Royal Dutch Petroleum and Shell Transport became
partners in 1907 and decided to share their cash flows on a
basis of 60-40
• Arbitrage: if Royal Dutch is overvalued buy Shell

• Limit: it is possible that the prices diverge even more from

the parity ratio on the short term, generating losses for the
arbitrageur

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 6. Behavioral finance
Limits to arbitrage: Deviations from parity 1980-2004

Source: Brealey et al, 2005 49

 6. Behavioral finance
Irrational market behavior

• Deviation from rationality according to some basic

principles:

1. Overconfidence
2. Representative bias/biased judgments
3. Herd mentality/mimetism
4. Conservatism
5. Loss aversion

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 6. Behavioral finance
Overconfidence
Investors
– Overestimate their own knowledge
– Underestimate risks
– Exaggerate their ability to control events

Investors are:
– Mistakenly convinced that they can beat the
market
– Selective memory of success: success better
remembered than failure
Summing up: they practise self-deception
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 6. Behavioral finance
Representative bias (take conclusions based on an insufficient
number of observations, excessive extrapolation from recent
evidence)
– Bet on black when playing roulette after black got out
several times, expecting the series of black to continue

– When tossing a coin and getting 5 times head, many

people are convinced that the probability that at the
next toss you get tail is higher than that of getting head

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 6. Behavioral finance
Conservatism
- the too slow speed at which individuals update
their beliefs given new information

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 6. Behavioral finance
Herding/Mimetism
• In general: groups tend to make better decisions than
individuals,
but:

• Groups of individuals will sometimes reinforce one

another into believing that some incorrect point of view
is, in fact, the correct one -> crowd behaviour

• Explains the speculative bubbles

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 6. Behavioral finance
Herding/Mimetism
• Example: INTERNET BUBBLE

– Investors were purchasing assets because their

prices were rising without paying attention neither
to their expected dividends nor to the projections of
future profits

– Mutual-fund managers also show herd behaviour

(protective measure for their performance
evaluation)

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 6. Behavioral finance
Herding/Mimetism
• Observed facts:

– Investors choose the funds with best recent past

performance
– Investors buy when markets are bullish (up)
– Investors sell when the markets are bearish (down)

• Lesson: Avoid herd behaviour in the stock market!

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 6. Behavioral finance
Loss aversion
• Prospect theory (Kahneman and Tversky):

– Investors choices are motivated by the values they assign

to gains and losses
– Losses are more undesirable than gains are desirable
– Extreme loss aversion helps explain seller’s reluctance to
sell their properties at loss

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 6. Behavioral finance
Loss aversion

• Investors do not make the same choices regarding gains

or losses:
– Sell too fast good investments and keep the bad
ones
– Prefer a probability of 50% of losing 100 rather than
being sure of losing 50
– Prefer being sure of winning 50 rather than having a
chance out of 2 of winning 100

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