market efficiency, behaviroal finance and creating superior portfolio
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Market Efficiency and Behavioral Finance
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Efficient Market Hypothesis
(EMH)
Do security prices reflect information ?
Why look at market efficiency?
Implications for business and corporate
finance
Implications for investment
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Random Walk and the
EMHRandom Walk - stock prices are random
Actually submartingale Expected price is positive over time
Positive trend and random about the trend
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SecurityPrices
Time
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Random Price ChangesWhy are price changes random?
Prices react to information
Flow of information is random
Therefore, price changes are random
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EMH and CompetitionStock prices fully and accurately reflect
publicly available information.Once information becomes available,
market participants analyze it.
Competition assures prices reflect
information.
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Forms of the EMH Weak
Semi-strong
Strong
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Types of Stock AnalysisTechnical Analysis - using prices and volume
information to predict future prices.
Weak form efficiency & technical analysis
Fundamental Analysis - using economic and
accounting information to predict stock prices.
Semi strong form efficiency & fundamentalanalysis
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Active or Passive
ManagementActive Management
Security analysis
Timing
Passive Management
Buy and HoldIndex Funds
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Empirical Tests of Market
EfficiencyEvent studies
Assessing performance of professionalmanagers
Testing some trading rule
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How Tests Are Structured1. Examine prices and returns over time
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0 +t-t
Announcement Date
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How Tests Are Structured
(contd)2. Returns are adjusted to determine if they areabnormal.
Market Model approach
a. Rt= a
t+ b
tR
mt+ e
t
(Expected Return)
b. Excess Return =
(Actual - Expected)
et= Actual - (a
t+ b
tR
mt)
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How Tests Are Structured
(contd)2. Returns are adjusted to determine if they are
abnormal.
Market Model approachc. Cumulate the excess returns overtime:
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Issues in Examining the
ResultsMagnitude Issue
Selection Bias Issue
Lucky Event Issue
Possible Model Misspecification
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What Does the Evidence
Show?Technical Analysis
Short horizon
Long horizon
Fundamental Analysis
Anomalies Exist
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AnomaliesSmall Firm Effect (January Effect)
Neglected Firm
Market to Book Ratios
Reversals
Post-Earnings Announcement Drift
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Explanations of
AnomaliesMay be risk premiums
Behavioral Explanations
Information Processing Errors
Behavioral BiasesLimits to Arbitrage
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Information ProcessingForecasting Errors
Overconfidence
Conservatism
Sample Neglect and Representativeness
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Behavioral BiasesAnchoring
Mental Accounting
Confirmation & Hindsight bias
Gamblers fallacyHear behaviour
Over confidence
Overreaction and availability bias
Prospect theory
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Limits to ArbitrageFundamental Risk
Implementation Costs
Model Risk
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Mutual Fund PerformanceSome evidence of persistent positive and
negative performance.
Potential measurement error forbenchmark returns.
Style changes
May be risk premiums
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