Presentation on theme: "The Efficient Market Hypothesis"— Presentation transcript:
1 The Efficient Market Hypothesis BM410 InvestmentsThe Efficient Market HypothesisorIs there really a free lunch?
2 Objectives R. Review Portfolio Theory up to today A. Understand the efficient market hypothesis and why securities prices should be essentially unpredictableB. Be able to formulate investment strategies that make sense in informationally efficient markets.C. Understand the tests of market efficiency and cite evidence that supports and contradicts the EMHD. Understand some market anomalies to the EMH
3 Review of Financial Theory What we have discussedA two asset portfolio – with leverageModern Portfolio TheoryThe development of the efficient frontierThe efficient frontier with CALsCAPM, and its movement toward BetaAPT
4 Two Assets and the CAL s CAL: (Capital Allocation Line) E(r) P Risk premiumE(rp) -rf = 8%) S = 8/22rf = 7%FSlope: Reward to variability ratio: ratio of risk premium to std. dev.sP= 22%This graph is the risk return combination available by choosing different values of y. Note we have E(r) and variance on the axis.
5 MPT: The Impact of Correlation E(r)r = 1r = -1r = .313%8%12%20%St. DevMPT: The Impact of Correlationr = 0TWO SECURITY PORTFOLIOS WITH DIFFERENT CORRELATIONS
6 The Efficient Frontier IndividualassetsGlobalminimumvarianceportfolioMinimumvariancefrontierThe minimum-variance frontier of risky assetsSt. Dev.
7 The Efficient Frontier with CALs CAL (P)CAL (A)MMPPCAL (Globalminimum variance)AAGFsPP&FMA&F
8 CAPM and The Security Market Line Notice that instead of using standard deviation, the SML uses BetaSML Relationshipsb = [COV(ri,rm)] / sm2Slope SML = E(rm) – rf = market riskpremiumE(r)SMLE(rM)rfSML = rf + b[E(rm) - rf]ßß= 1.0M
9 CAPM: Expected Return– Beta Relationship E(rM) - rf = E(rs) - rfbsIn other words, the expected rate of return of an asset exceeds the risk-free rate by a risk premium equal to the asset’s systematic risk (its beta) times the risk premium of the market portfolio. This leads to the familiar:E(rs) = rf + bs [E(rM) - rf ]
10 APT and the Security Characteristic Line Excess Returns (i)SCL...Plot of a company’s excess return as a function of the excess return of the market........................Excess returnson market index.......................Ri = a i + ßiRm + ei
11 A. Efficient Market Hypothesis and why Securities Prices should be Unpredictable What is the Efficient Market Hypothesis (EMH)?A hypothesis (or theory) that security prices reflect all available information, i.e., historical, public, and non-publicA framework for trying to understand the movements in stock pricesProbably the single most important paradigm in financeWhy is it important?It helps us understand formulate a basis for various investment strategies and also explain why prices move the way they do
12 What is Market Efficiency? What is efficiency?The quality or degree of being efficient, effective operation as measured by a comparison of production/energy with cost/outputAre their different types of efficiency?Operational efficiencyThe measure of how well things function in terms of speed of execution and accuracyInformational efficiency (i.e. market efficiency)The measure of how quickly and accurately the market reacts to new information
13 Degrees of Informational Efficiency Weak formStock prices reflect all information contained in the history of past trading—no benefit from past pricesSemi-strong formStock prices reflect all publicly available information — no benefit from 10Ks, 10Qs, etc.Strong formStock prices reflect all relevant information, including past, public, and inside information– no benefit from any insider informationSFSSFWeak Form
14 Random Walk and the EMH What is a Random Walk? The notion that stock prices are random and unpredictableSince information comes randomly, then its impact on stock prices should be random as wellPrice changes are actually a sub martingaleThe expected price is generally positive over timeIt has a positive trend and is random about the trend
15 Random Walk with Positive Trend SecurityPricesTime
16 Efficient Markets Hypothesis and Competition Stock prices fully and accurately reflect publicly available informationOnce information becomes available, market participants analyze itParticipants will buy and sell based on that new informationCompetition assures prices reflect information, as securities will be bought and sold until the point that all new information is embedded in the price
17 Are there Other Theories? Semi-efficient market hypothesis (among others)A cousin of the EMHStates that some stocks are priced more efficiently than othersThis is generally used to support the notion of tiering in the marketsAnalysts can only follow so many stocks, so they follow the largestThe smaller are less followed, and hence are more likely to be less-efficiently priced
18 QuestionsAny questions of the Efficient Market Hypothesis and why stock prices should be unpredictable?
19 Problem #1Which of the following most appears to contradict the proposition that the stock market is weak-form efficient? Explain.A. Over 25% of mutual funds outperforms the markets on average.B. Insiders earn abnormal trading profitsC. Every January, the stock market earns above normal returns.
20 Answer #1c. Predictable returns should not occur according to the weak-form efficient market hypothesis. Higher than average returns in the month of January each year contradicts the weak-form EMH.
21 Investment Strategies in Informationally Efficient Markets Does your view of efficient markets have an impact on how you manage a portfolio?Stock analysis assumes the markets are not weak and semi-strong form efficientTechnical Analysis - using prices and volume information to predict future pricesViolates weak-form efficiencyFundamental Analysis - using economic and accounting information to predict stock pricesViolates semi-strong form efficiency
22 Implications of EMH Efficiency Active ManagementIf markets are efficient, then it depends on the degree of efficiencySecurity analysis assumes you can add even a little bit of valueIt doesn’t have to be too much if you are managing a large fundTiming assumes you can make decisions regarding the attractiveness of various asset classes
23 Implications of EMH Efficiency Passive ManagementThis is useful and cheapBuy and HoldSince the EMH indicates prices are at a fair value, it makes no sense to buy, sell, or do any type of analysisIndex FundsIf you can’t beat them, join them – mimic a broad benchmark of securities, i.e. the S&P 500
24 Market Efficiency and Portfolio Management What if the markets are efficient? Is there still a role for portfolio management?Even if the markets are efficient, a role exists for portfolio managementDetermining an appropriate risk levelUnderstanding tax considerationsTaking into account other individual investment considerations for a portfolio
25 QuestionsDo you understand how the implications of the EMH will affect trading strategies?
26 Problem #2Some scholars contend that professional managers are incapable of outperforming the market. Others come to an opposite conclusion. Compare and contrast the assumption about the stock market that support (a) passive portfolio management and (b) active portfolio management.
27 Answer #2Assumptions that support passive management are that all available information is already reflected in the price of stocks. The fees for passive management are minimal.Assumptions that support active management are that there are pockets of market inefficiency. Active management is more feasible for managers of large portfolios.
28 Understand Empirical Tests of Market Efficiency How are tests made of the Efficient Market Hypothesis?Most common are:Performance Attribution: Assessing performance of professional managersTesting of filter / trading rulesEvent studies
29 Performance Attribution Results from Mutual Fund and Professional Manager PerformanceThere is some evidence of persistent positive and negative performanceThe problem is that it takes time to determine bothSometimes positive returns are from managers investing outside their benchmarkPotential measurement error for benchmark returnsStyle changes have occurredMay be risk premiums involvedThere is a superstar phenomenon (Lynch, Buffett, etc.)
30 Testing of Filter/Trading Rules Very limited support of trading rulesA trading rule might suggest you buy when the stock passes its 360 day moving average and sell when it drops below its 45 day moving averageThose who make money on trading rules are generally those selling the booksOnce a trading rule is known, it is generally exploited and then the inefficiency is lost
31 Event Studies How Tests Are Structured 1. Examine prices and returns over timeFormulate a hypothesis (and choose an appropriate test statistic)2. Adjust returns to determine if they are abnormalSelect a model, i.e. Rt = at + btRmt + et and compare expected returns to actual returns3. Compare actual results with expected resultsSee how well your actual results were predicted by your model
32 Event Studies (continued) Results of Event Studies:If the results are good, you invest money with the test—you do not let anyone know, but make lots of money and retire earlyIf the results are bad, you publish the results and make tenure, or try to sell books and tapes via the radio and TV to unsuspecting buyers who don’t know any better
33 Event Studies (continued) +tAnnouncement DateReturns Surrounding the Event
34 Final Thoughts on Market Efficiency Key Issues:Magnitude IssueA 1 basis point improvement for a $100K portfolio is much less important than for a $10bn portfolioSize mattersSelection Bias IssueInvestment schemes that don’t work are published, and those that do are used to make moneyWe only hear of those that don’t work
35 Market Efficiency (continued) Lucky Event IssueIt is more difficult to prove skill than luckIt takes more time to prove skillPossible Model MisspecificationPerhaps the market is efficient but the model is incorrectly statedWe may be using the wrong model
36 Market Efficiency (continued) What Does the Evidence Show?If it sounds too good to be true, it usually isIt must make good common business senseCommon sense is all too uncommonTechnical AnalysisMay be helpful for certain eventsBut generally has not shown excess returns for a longer period of time
37 Market Efficiency (continued) Fundamental AnalysisHas been shown to add valueBut analysts must forecast firms earnings better than everyone elseAnomalies ExistBut invest in them at your perilAn anomaly discussed means it is knownIt is less like to do the same next time because others will be watching for it as well.
38 Understand Anomalies to the EMH What is a market anomaly?A market anomaly refers to price behavior that differs from the behavior predicted by the efficient market hypothesis.An anomaly discussed means it is knownIt is less like to do the same next time because others will be watching for it as well.Are their anomalies that are known?
39 Anomalies (continued) Price Earnings EffectPortfolio’s of low P/E stocks have exhibited higher average risk-adjusted returns than higher P/E StocksInvestors prefer cheaper stocks even if risk levels are the same.Small Firm EffectSmaller firms generally earn higher returnsMay be tied to fact that ownership of smaller firms is left to smaller investors who require a higher return to invest.
40 Anomalies (continued) January EffectStocks tend to exhibit a higher return in January than any other month (higher for smaller stocks)May be tied to tax-loss selling or window dressing at year-endNeglected Firm EffectFirms not followed by analysts tend to perform better than those followedBecause costs are higher to analyze smaller firms, investors require a higher rate of return to invest in less liquid stocks
41 Anomalies (continued) Liquidity EffectLess liquid stocks sometimes perform better than more liquid stocksInvestors may require a higher return premium to compensate for lower liquidityMarket to Book RatiosStocks with lower price to book ratios (or higher book to market ratios) perform betterInvestors prefer to invest in cheaper stocks (in reference to their assets)
42 Anomalies (continued) ReversalsExtreme stock market performance tends to reverse itself, i.e. reversion to the mean.Losers rebound and winners fallValue Line EnigmaStocks rated highly by Value Line perform betterInvestors may read Value Line
43 Anomalies (continued) Post-Earnings Announcement DriftThe effect of earnings announcements continue for many days after the announcementMay be due to trading costs, particularly for smaller companies
44 Problem #3 What is a market anomaly? A market anomaly refers to: A. An exogenous shock to the market that is sharp but not persistent.B. A price or volume even that is inconsistent with historical price or volume trends.C. A trading or pricing structure that interferes with efficient buying and selling of securities.D. Price behavior that differs from the behavior predicted by the efficient markets hypothesis.
45 Answer #3d). A market anomaly refers to price behavior that differs from the behavior predicted by the efficient market hypothesis.
46 QuestionsDo you understand the tests of market efficiency and can you cite evidence that supports or contradicts the EMH?
47 Problem #4Prices of stocks before stock splits show on average consistently positive abnormal returns. Is this a violation of the EMH?
48 Answer #4 No this is not a violation of the EMH. Usually stock splits occur as a response to good performance which drives up the stock price and leads managers to split the stock.When the managers announce a stock split the good performance of the stock is already accounted for in the price of the stock.
49 Final Thoughts on Securities Analysis Securities Analysis is like a horse showBut its not determining which is the best horseBut which horse will the judges consider the best horse!You have to decide!!!!!!!
50 Review of ObjectivesA. Do you understand the efficient market hypothesis and why securities prices should be essentially unpredictable?B. Can you formulate investment strategies that make sense in informationally efficient markets?C. Do you understand the tests of market efficiency and cite evidence that supports or contradicts the EMH?D. Do you understand anomalies that exist to the EMH?