Efficient Capital Markets

Why Should the Markets Be

Efficient?
Premises of An Efficient Market
01 A large number of competing 02 New information
profit-maximizing participants regarding securities
analyze and value securities, comes to the market
each independently of the in a random fashion
others
03 Profit-maximizing investors cause security
prices to adjust rapidly to reflect the effect of
new information
The Results

Security price changes In an efficient market, the expected returns

should be independent implicit in the current price of a stock should
and random be consistent with the perceived risk of the
stock

The security prices that prevail at any time

should be an unbiased reflection of all
currently available information
Efficient Market Hypotheses (EMH)

Random Walk Efficient Market

Hypothesis Hypothesis (EMH)
Changes in security prices Divided into three sub-
occur randomly hypotheses depending on
the information set involved

Fair Game Model

Current market price reflects all
available information about a
security and the expected return
based upon this price is
consistent with its risk
Weak-Form Efficient Market Hypotheses (EMH)

01 02
Current prices reflect all security-market This implies that past rates of
historical information, including the return and other market data
historical sequence of prices, rates of should have no relationship with
return, trading volume data, and other future rates of return
market-generated information

03 In short, prices reflect all historical

information
Semistrong-Form Efficient Market Hypotheses (EMH)

01 02
Current security prices reflect all public This implies that decisions made
information, including market and non- on new information after it is
market information public should not lead to above-
average risk-adjusted profits
from those transactions

03 In short, prices reflect all public

information
Strong-Form Efficient Market Hypotheses (EMH)

01 02
Stock prices fully reflect all This implies that no group of
information from public and private investors should be able to
sources consistently derive above-average
risk-adjusted rates of return

03 This assumes perfect markets

in which all information is cost-
free and available to everyone
04 In short, prices reflect all public
and private information
at the same time
Event Studies

Stock split studies show Initial public offerings seem

that splits do not result in to be underpriced by
abnormal gains after the almost 18%, but that varies
split announcement, but over time, and the price is
before adjusted within one day
after the offering

Listing of a stock on a Stock prices quickly adjust

national exchange such as to unexpected world
the NYSE may offer some events and economic news
short-term profit and hence do not provide
opportunities for investors opportunities for abnormal
profits
Event Studies

Announcements of Stock prices rapidly adjust

accounting changes are to corporate events such
quickly adjusted for and do as mergers and offerings
not seem to provide
opportunities

Strong support from In contrast, studies on predicting rates of

numerous event studies return for a cross-section of stocks indicates
with the exception of markets are not semistrong efficient.
exchange listing studies Dividend yields, risk premiums, calendar
patterns, and earnings surprises
 Corporate Insider Trading
Corporate insiders include major corporate officers, directors, and
owners of 10% or more of any equity class of securities

Insiders must These insider Corporate insiders This implies that

report to the SEC trades are generally many insiders had
each month on made public experience above- private information
their transactions about six average profits from which they
in the stock of the weeks later and especially on
firm for which they allowed to be purchase derived above-
are insiders studied transactions average returns on
their company
stock
Security
Analysts

Tests have considered whether it

is possible to identify a set of
analysts who have the ability to
select undervalued stocks

The analysis involves determining whether, after a

stock selection by an analyst is made known, a
significant abnormal return is available to those who
follow their recommendations
Professional Money Managers

Trained professionals, If any investor can If any non-insider can obtain inside
working full time at achieve above- information, it would be this group due
investment average returns, it to the extensive management
management should be this group interviews that they conduct
Behavioral Finance
It is concerned with the analysis of various psychological traits of individuals and how
these traits affect the way they act as investors, analysts, and portfolio managers

The emphasis has been on identifying portfolio anomalies that

can be explained by various psychological traits. Three
“Tributaries”

Psychology
Social psychology
Neurofinance
Behavioral Finance
Explaining Biases
Prospect Theory
 Contends that utility depends on
deviations from moving reference
point rather than absolute wealth
Overconfidence (confirmation bias)
 Look for information that supports their
prior opinions and decision

Noise Traders
 Influenced strongly by sentiment, they tend
to move together, which increases the
prices and the volatility

Escalation Bias
 Put more money into a bad investment
 Fusion Investing
The integration of two elements of
investment valuation-fundamental
value and investor sentiment

During some periods, investor

sentiment is rather muted and noise
traders are inactive, so that
fundamental valuation dominates
market returns

In other periods, when investor

sentiment is strong, noise traders are
very active and market returns are
more heavily impacted by investor
sentiments

Behavioral Finance
Implications of
Efficient
Capital
Markets
Overall, the results of many On the other hand, What are the implications for
studies indicate the capital there are substantial investors in light of these mixed
markets are efficient as instances where the evidence?
related to numerous sets of market fails to rapidly Technical Analysis
information adjust to public Fundamental Analysis
information Portfolio Management
EMH and Technical Analysis
Assumptions of technical analysis directly
oppose the notion of efficient markets

Technicians believe that new information is not

Technical analysts develop immediately available to everyone, but
systems to detect movement to disseminated from the informed professional
a new equilibrium (breakout) first to the aggressive investing public and then
S W
and trade based on that
to the masses
Technicians also believe that investors do
O T
If the capital market is weak-
form efficient, a trading system not analyze information and act immediately
that depends on past trading
data has little value given higher Stock prices move to a new equilibrium after
trading costs the release of new information in a gradual
manner, causing trends in stock price
movements that persist for periods of time
EMH and Fundamental Analysis
o Fundamental analysts believe that there is a basic intrinsic value for
the aggregate stock market, various industries, or individual
securities and these values depend on underlying economic factors
o Investors should determine the intrinsic value of an investment at a
point in time and compare it to the market price
o If you can do a superior job of estimating intrinsic value, you can
make superior market timing decisions and generate above-average
returns
o Intrinsic value analysis involves:
o Aggregate market analysis
o Industry and company analysis
Aggregate Market Analysis

EMH implies that examining only past

A B C D
A economic events is not likely to lead to
outperforming a buy-and-hold policy
because the market adjusts rapidly to
known economic events

B Merely using historical data to

estimate future values is not sufficient

You must estimate the relevant

C variables that cause long-run
movements
 Industry and Company Analysis
 Important relationship
 Wide distribution of returns between expected
from different industries earnings and actual
and companies justifies earnings
industry and company  Accurately predicting
analysis earnings surprises
 Strong-form EMH indicates
likely existence of superior
 Must understand the analysts
variables that effect rates
of return and Do a superior  Studies indicate that
job of estimating future fundamental analysis
values of these relevant based on E/P ratios, size,
valuation variables, not just and the BV/MV ratios can
look at past data lead to differentiating
future return patterns
Fundamental
Analysis
Conclusion
Estimating the relevant variables is as
much an art and a product of hard work as
it is a science

Successful investor must understand what variables

are relevant to the valuation process and have the
ability and work ethic to do a superior job of
estimating these important valuation variables
 EMH and Portfolio Management

Portfolio Managers with

Superior Analysts

The market for these neglected

stocks may be less efficient than the
market for large well-known stocks

Concentrate efforts in mid-cap stocks that do not receive

the attention given by institutional portfolio managers to
the top-tier stocks
EMH and Portfolio Management
Portfolio Maintain the desired risk level by rebalancing
Managers the portfolio whenever necessary AND
without Minimize total transaction costs
Superior
Analysts Diversify completely on a global basis to
eliminate all unsystematic risk

Construct the appropriate portfolio

Determine and quantify your client's

risk preferences
 EMH and Portfolio Management
The Rationale and Use of Index Insights from Behavioral
Funds and Exchange-Traded Finance
Funds
Growth companies will usually not
Efficient capital markets and a lack be growth stocks due to the
of superior analysts imply that many overconfidence of analysts
portfolios should be managed regarding future growth rates and
passively (so their performance valuations
matches the aggregate market, Add Text
minimizes the costs of research and Notion of “herd mentality” of
trading) analysts in stock
Institutions created market (index) recommendations or quarterly
funds which duplicate the earnings estimates is confirmed
composition and performance of a
selected index series
THANK YOU