fin124 - market efficiency (1)
TRANSCRIPT
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Market Efficiency
Cocabo, Dayrit, Lok, Sasotona, Son
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Outline
I. The Concept of Market Efficiency
II. Forms of Market Efficiency
III. Evidence of Market Efficiency
IV. Implications for Analysis and Portfolio ManagemeV. Market Pricing Anomalies
VI. Behavioral Finance
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The Concept of Market Efficiency
Definition:
An efficient capital market is one wherein the prices
securities adjust rapidly to the arrival of new informa
therefore, the assumption is that the current prices o
securities reflect all the information about the securi
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The Concept of Market Efficiency
First Assumption:
A large number of profit-maximizing participants ana
value securities, each independent of the others.
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The Concept of Market Efficiency
Second Assumption:
New information regarding securities comes to the m
random manner, and the timing of one announceme
independent of others.
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The Concept of Market Efficiency
Third Assumption:
The buy and sell decisions of the profit-maximizing i
cause security prices to adjust rapidly to reflect the e
new information.
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The Concept of Market Efficiency
Price adjustment is imperfect, but unbiase● Market may overadjust or underadjust
● Impossible to predict which will occur at any give
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The Concept of Market Efficiency
● Prices adjust quickly because investors compete
from new information
● Impossible to predict which will occur at any give
● Combined effect: price changes are independenrandom
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The Concept of Market Efficiency
Therefore, in an efficient market, the expected retur
in the current price of the security should reflect its r
Investors should receive a rate of the return that is c
with the perceived risk of the security.
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The Concept of Market Efficiency
Efficient Market Hypothesis (EMH)
The buy and sell decisions of the profit-maximizing i
cause security prices to adjust rapidly to reflect the e
new information.
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● Weak-Form EMH● Semistrong-Form EMH
● Strong-Form EMH
Forms of Market Efficiency:
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Weak-Form EMH
● Assumption: Current stock prices fully reflect all s
market information, including historical data
● Implication: Past rates of return and other historic
data have no relationship with future rates of retu
● Therefore: Gain little from using any trading rule
past rates of return/past security market data
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Weak-Form EMH Example:
1) A CEO of a firm has inside information about a pa
stock
2) He tells his friends first, who buy the stock before
public knows of this information
3) There is low efficiency in the market
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Semistrong-Form EMH
● Assumption: Current stock prices fully reflect all p
information, which also includes all nonmarket in
● Implication: Investors who trade based on these
public information cannot gain above-average be
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Semistrong-Form EMH Example:
1) CEO’s friends (company officers, insiders, family
know information slightly before the public
2) Information flows semi-quickly; those who are to
have a slight advantage
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Strong-Form EMH
● Assumption: Current stock prices fully reflect all
information from public and private sources
● Implication: No monopolistic access to informatio
to the formation of prices
● Therefore: No investor will be able to benefit mo
another since stock prices reflect all information
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Strong-Form EMH Example:
1) CEO, friends, and public learn of news about the
the same time
2) Nobody can have an advantage; there is no data
provide additional valuable information to investo
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Weak-Form Hypothesis: Tests and Results
I. Statistical Tests of Independence
A. Autocorrelation test → insignificant correlation in stock
time
B. Runs test → independence of stock price changes ove
II. Tests of Trading Rules
→ Most evidence show that most trading rules tested have able to beat a buy-and-hold policy
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Semistrong-Form Hypothesis: Tests and Res
I. Event Studies (examines how stock prices adjust to signific
economic events)
→ Ex. of events: stock splits, IPO, unexpected world/econom
etc.
→ Results mostly support the Semistrong-Form EMH
II. Time Series Analysis (determines whether any public info w
superior estimates of returns
→ Revealed evidence/anomalies that counters EMH
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Strong-Form Hypothesis: Tests and Results
Analyzed the performance of 3 major investment groups:
1. Corporate Insiders
→ apparently have monopolistic access to inside information
→ does not really support EMH
2. Security Analysts
→ have opinions/recommendations which can be considered sign
→ mixed results but more on supports EMH
3. Professional Money Managers
→ does not have access to inside information; does not outperfor
→ relatively supports EMH
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Evidence of Market Efficiency
It is impossible to regularly beat an efficient market
1. Random Walk Theory: Stocks take random, unpredictable paths.
a. Having accurately forecasted does not ensure that same inv
analyst will be lucky enough to do so again in the future.
2. Performance of investment analysts
a. For every person that “wins” in outperforming the market, th
“loser” to hold the equilibrium of the market
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Implications for Analysis and Portfolio Manag
Technical Analysis
- A method of evaluating securities by analyzing m
activity, such as past prices and volume
- Use charts and patterns to suggest future activity
- Cannot be used under any form of market efficieeven weak efficiency, prices already reflect past
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Implications for Analysis and Portfolio Manag
Fundamental Analysis
- Attempts to measure securities’ intrinsic value by
macroeconomic and company-specific factors (e
conditions, current management, etc.)
- Can only be used in weak form efficiency (in semform, prices already reflect current public informa
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Implications for Analysis and Portfolio Manag
Portfolio Management
- Goal of portfolio management: outperform a spe
benchmark with specific benchmark ideas
- Market efficiency implies that this is unachievable
portfolio manager should not be able to achieve average returns
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Implications for Analysis and Portfolio Manag
Portfolio Management
- No group of investors should be able to consiste
the market using a common investment strategy
- Efficient markets have self-correcting mechanism
inefficiencies appear regularly, but disappear as investors find them and trade on them
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Implications for Analysis and Portfolio Manag
Portfolio Management
- Thus, portfolio managers should focus on risk an
given that market efficiency implies that consiste
average returns are unachievable
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Market Pricing Anomalies
1. Small-firm effect
a. Greater amount of growth opportunities than large companiesb. More volatile business environment
c. Lower stock prices resulting to higher price appreciation
2. Calendar effects (January anomaly)
a. Stocks that underperform in the 4th quarter of last year tend to perf
even outperform the market in January
b. Losses are used to offset capital gains taxes
c. Stock prices increase in January due to an increase in buying, resul
drop in prices of stocks in December
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Market Pricing Anomalies
3. Low price-to-book value:
a. Underappreciated stocks moving towards average price to book ratio va
b. Could either mean than the stock is undervalued or
c. The company is underperforming
4. Reversals:
a. Yesterday’s top performers become tomorrow’s under performers and v
b. Top performing stocks become more expensive, while underperforming
cheaper
c. In relation to b, overpriced stocks perform less while undervalued stocks
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Market Pricing Anomalies
5. Neglected Firm
a. Caused by lack of information and interest
b. Once discovered by investors, the stock’s value will increase
c. However, research shows that this anomaly does not really e
d. Small firms look to outperform because of their size, but for
that are neglected, there is no real increase in performance.
6. Momentum
a. The price of a security will continue to move in the same dire
b. Used for short term movements in a stock’s price
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Market Pricing Anomalies
7. Days of the week: Behavioral finance theories
a. End of the week optimism (BF hypothesis)
i. Positive moods going into the weekend; Positive re
Friday, lots of trading
b. Start of the week pessimism (More cognitive evidence)
i. Investors update themselves on company news over
ii. Leads to risk-averse Monday decisions, market goes
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Behavioral Finance
Definition
Considers how various psychological traits affect ho
individuals or groups act as investors, analysts, and
managers (Reilly and Brown, 2012)
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Behavioral Finance
Three Factors
1. Psychology - Individual behavior
2. Social Psychology - Behavior affected by others
3. Neurofinance - Nature of cognitive processes tha
to our financial decisions
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Behavioral Finance
Explaining Biases
1. Holding “losers” for too long and selling “winners
soon (Investors fear losses more than they value
a. Belief perseverance - reluctant to change min
despite contrary informationb. Anchoring - starting with an arbitrary value fo
failing to adjust as time passes
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Behavioral Finance
Explaining Biases
2. Overconfidence in forecasting for growth compan
(Overemphasizing growth, focusing only on good ne
a. Confirmation bias or representativeness (actively looking for
b. Hindsight bias (people overvalue one person’s prediction aft
something right)
c. Self-attribution bias (success to personal effort, failure to bad
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Behavioral Finance
Explaining Biases
3. Noise traders (increase market volatility)
● overreact to news
● follow the herd
● have poor timing
4. Escalation bias
● rationalizes a bad investment through negative results, instead o
● allows investment to become a sunk cost
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Behavioral Finance
Fusion Investing
An approach that integrates both traditional and beh
paradigms to create a more robust investment mode
Basically, the application of behavioral finance into t
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Behavioral Finance
Fusion Investing
Example: Discounting securities indefinitely
● Takes into account future dividend/market trends and noise trade
● Fundamental finance variable, and behavioral finance variable
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Conclusion
Is there market efficiency?
● Most say markets can never be completely weak
implying that semi-strong efficiency is the most c
● Philippines: Leans towards weak efficiency (Aqui
○
Fair speed of information absorption, except during political/stress
○ Asymmetrical information disclosure: large shareholders inst
access to information for companies they control
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Conclusion
Is there market efficiency?
● “If all participants were to believe that the marke
efficient, nobody would seek extraordinary profit
the force that keeps the wheel of the market turn
● Age of IT: Electronic trading; prices adjust faster● However, not all information is quality informatio
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Sources
1) Investment Analysis & Portfolio Management (Reilly, Brown) 10th
2) “What Is Market Efficiency?”, “Securities Markets - Weak, Semi-St
Strong EMH,” “Market Anomalies,” www.investopedia.com. Acce
2016.
3) Informational Efficiency Characteristics of the Philippine Stock Ma
Aquino. 2006.
http://www.investopedia.com/