Lesson 2 Redux

Why would predictable stock prices be evidence AGAINST market efficiency?

Because if future price movements were predictable using currently available information, investors could consistently earn abnormal returns. This would imply that stock prices do not fully reflect available information, violating the Efficient Market Hypothesis.

Explain the logical connection between EMH and random walk theory.

EMH states that stock prices fully reflect all available information. Therefore, only new information can change prices. Since new information is unpredictable by definition, stock price changes must also be unpredictable, resulting in a random walk.

Why do random stock price movements not necessarily imply irrational markets?

Random price movements may occur because markets efficiently incorporate all currently available information into stock prices. As only unpredictable new information can affect prices, price changes appear random despite markets operating rationally.

If investors discover a reliable model predicting future stock price increases, what would happen in an efficient market?

Investors would immediately buy the underpriced stocks, causing prices to rise instantly until the profit opportunity disappears. The market would quickly incorporate the information into current prices.

What did Maurice Kendall discover in 1953 when examining stock price movements?

Maurice Kendall found that stock price movements appeared random and unpredictable, meaning he could not identify consistent patterns in price changes.

Why did economists initially interpret Kendall’s findings as evidence of irrational markets?

Economists initially believed random stock price movements suggested that markets were driven by irrational investor psychology (“animal spirits”) rather than logical economic behaviour.

Why did economists later reinterpret Kendall’s findings as evidence of efficient markets?

Economists later argued that random price movements actually indicate efficient markets because prices rapidly incorporate all available information, leaving only unpredictable new information to affect prices.

Why would predictable stock prices create profit opportunities?

If stock prices were predictable, investors could consistently buy undervalued stocks and sell overvalued stocks to earn abnormal profits.

Why would profitable prediction strategies disappear in an efficient market?

Once investors discover a profitable trading strategy, they immediately exploit it through buying or selling, causing stock prices to adjust rapidly until the profit opportunity disappears.

What would happen if investors knew a stock priced at £100 would soon rise to £110?

Investors would immediately buy the stock, increasing demand and causing the price to rise instantly toward £110 as the market incorporates the information.

In an efficient market, what relationship exists between available information and stock prices?

In an efficient market, stock prices already fully reflect all available information relevant to the firm.

What was Eugene Fama’s contribution to the Efficient Market Hypothesis (EMH)?

Eugene Fama formally developed and popularised the Efficient Market Hypothesis in his 1970 paper “Efficient Capital Markets.”

According to EMH, what causes stock prices to change?

Only new information causes stock prices to change because existing information is already reflected in current prices.

Why are stock price changes unpredictable in an efficient market?

Stock price changes are unpredictable because they are driven only by new information, and new information is unpredictable by definition.

Why would predictable stock prices be evidence against market efficiency?

Predictable stock prices would imply that investors could consistently earn abnormal profits using currently available information, meaning prices do not fully reflect available information and the market is inefficient.

Explain the relationship between EMH and random walk theory.

EMH states that stock prices fully reflect all available information. Therefore, only unpredictable new information can change prices, causing stock prices to follow a random walk.

Why do random stock price movements not necessarily imply irrational markets?

Random stock price movements may reflect rational and efficient markets because prices continuously adjust to new information, which is inherently unpredictable.

How does investor competition contribute to market efficiency?

Investors continuously search for profit opportunities and rapidly trade on new information, causing prices to adjust quickly and reducing opportunities for abnormal profits.

Why are markets considered efficient from the perspective of investor competition?

Markets are considered efficient because investors continuously compete to identify undervalued or overvalued securities. Once profitable information is discovered, investors trade on it rapidly, causing prices to adjust and eliminating abnormal profit opportunities.

Why did Sanford Grossman and Joseph Stiglitz argue that perfectly efficient markets are impossible?

Grossman and Stiglitz (1980) argued that information gathering is costly and time-consuming. If markets were perfectly efficient and all information was already reflected in prices, investors would have no incentive to gather information. Without information gathering, markets would eventually become inefficient.

What is weak-form Efficient Market Hypothesis (EMH)?

Weak-form EMH states that current stock prices already reflect all past trading information, including historical prices, returns, and trading volume.

What type of analysis is considered ineffective under weak-form EMH?

Technical analysis is considered ineffective under weak-form EMH.

Why does weak-form EMH imply that technical analysis is fruitless?

Weak-form EMH implies technical analysis is fruitless because all past market data is already reflected in stock prices, preventing investors from consistently earning abnormal returns using historical price patterns.

What is semi-strong-form EMH?

Semi-strong-form EMH states that stock prices already reflect all publicly available information relating to a firm.

What information is included under semi-strong-form EMH?

Semi-strong-form EMH includes past trading data as well as publicly available fundamental information such as financial statements, earnings forecasts, management quality, patents, accounting practices, and news releases.

What type of analysis is considered ineffective under semi-strong-form EMH?

Fundamental analysis is considered ineffective under semi-strong-form EMH because all publicly available information is already reflected in stock prices.

What is strong-form EMH?

Strong-form EMH states that stock prices fully reflect all information, including both public information and private insider information.

Why is strong-form EMH considered unrealistic?

Strong-form EMH is considered unrealistic because insider information can sometimes provide investors with abnormal profit opportunities before the information becomes public.

How does insider trading regulation relate to strong-form EMH?

Regulations such as Rule 10b-5 of the Securities Exchange Act of 1934 restrict insider trading because insider information may allow certain investors to earn abnormal returns, suggesting that markets are not fully strong-form efficient.

Explain the hierarchical relationship between the three forms of EMH.

Strong-form EMH includes semi-strong-form and weak-form EMH because it assumes all information is reflected in prices. Semi-strong-form EMH includes weak-form EMH because public information includes past trading data.

If strong-form EMH is true, what does this imply about semi-strong and weak-form EMH?

If strong-form EMH is true, then semi-strong-form and weak-form EMH must also be true because all categories of information are reflected in prices.

If weak-form EMH is true, does this mean strong-form EMH must also be true?

No. Weak-form EMH only states that past trading information is reflected in prices and does not imply that insider information is also reflected.

Would corporate managers consistently earning abnormal returns on their company’s stock violate weak-form EMH?

No. Weak-form EMH only concerns past trading information and does not address insider information.

Would corporate managers consistently earning abnormal returns on their company’s stock violate strong-form EMH?

Yes. Strong-form EMH states that even insider information should already be reflected in stock prices, so insiders should not consistently earn abnormal returns.

What is technical analysis?

Technical analysis is the study of historical price movements and trading patterns in an attempt to identify recurring trends and predict future stock price movements.

Why does technical analysis contradict the Efficient Market Hypothesis (EMH)?

Technical analysis assumes that past trading patterns can predict future prices, implying that stock prices adjust slowly to information. This contradicts EMH, which states that prices rapidly incorporate available information.

Under weak-form EMH, is technical analysis useful? Explain why.

No. Under weak-form EMH, all past trading information such as historical prices and trading volume is already reflected in stock prices, preventing investors from consistently earning abnormal returns through technical analysis.

What is fundamental analysis?

Fundamental analysis is the assessment of a firm’s intrinsic value using factors such as earnings prospects, dividend expectations, interest rates, growth potential, and risk evaluation.

Under semi-strong-form EMH, is fundamental analysis useful? Explain why.

No. Under semi-strong-form EMH, all publicly available information is already reflected in stock prices, making it difficult for investors to consistently generate abnormal returns through fundamental analysis.

Why is finding “good companies” insufficient for generating abnormal returns under semi-strong-form EMH?

Investors must identify companies that perform better than market expectations, not simply good companies, because publicly known positive information is already incorporated into stock prices.

What is active portfolio management?

Active portfolio management involves attempting to outperform the market through strategies such as stock selection, market timing, and intensive research.

What are the disadvantages of active portfolio management?

Active portfolio management is expensive, research-intensive, and often fails to consistently outperform the market after accounting for fees and transaction costs.

What is passive portfolio management?

Passive portfolio management involves accepting market efficiency and aiming to match overall market performance rather than outperform it.

What are the advantages of passive portfolio management?

Passive portfolio management offers lower fees, broad diversification, simplicity, and lower trading costs compared to active management.

Give two examples of passive investment strategies.

Examples include investing in index funds and exchange-traded funds (ETFs) that track market indices.

What would happen to market efficiency if all investors adopted passive investment strategies?

If all investors became passive, fewer investors would analyse securities and trade on new information. As a result, prices would adjust less efficiently, allowing mispricing opportunities to persist. Therefore, passive investing depends on active investors to help maintain market efficiency.

Does EMH imply that portfolio managers are unnecessary? Explain why.

No. Portfolio managers still play important roles in diversification, tax planning, matching investments to investor risk preferences, and adapting portfolios to investors’ age and financial objectives.

How can inefficient markets lead to poor resource allocation?

In inefficient markets, overvalued firms may raise capital too cheaply while undervalued firms may struggle to obtain financing, leading to systematic misallocation of economic resources.

Are efficient markets the same as perfect foresight markets? Explain why.

No. Efficient markets do not perfectly predict the future. EMH only states that stock prices reflect currently available information, not that future events can be known with certainty.

What is an event study?

An event study is a statistical method used to measure the impact of a specific event, such as an earnings announcement or merger, on stock returns.

What is the expected return in an event study?

The expected return is the return that would normally be expected if the event had not occurred.

How are expected returns commonly estimated in event studies?

Expected returns are commonly estimated using the market model, CAPM, or historical relationships between the stock and market returns.

What is an abnormal return?

An abnormal return is the difference between a stock’s actual return and its expected return.

What does abnormal return measure in an event study?

Abnormal return measures the portion of stock return specifically attributable to the event being studied.

How is abnormal return calculated?

Abnormal Return = Actual Return − Expected Return

In an efficient market, how should stock prices behave following new public information?

In an efficient market, stock prices should adjust rapidly and accurately to new public information, causing abnormal returns to disappear quickly after the announcement.

Which form of EMH do event studies primarily test?

Event studies primarily test semi-strong-form EMH because they examine how rapidly publicly available information is incorporated into stock prices.

What are the three major issues involved in testing market efficiency?

The three major issues are the magnitude issue, selection bias issue, and lucky event issue.

What is the magnitude issue in EMH testing?

The magnitude issue refers to the possibility that small market inefficiencies may exist but are too small to exploit profitably after accounting for transaction costs, research costs, and portfolio size requirements.

Why does the magnitude issue create difficulties when evaluating EMH?

The magnitude issue makes it difficult to determine whether markets are truly efficient because some inefficiencies may exist but may not be economically exploitable in practice.

What is the selection bias issue in EMH testing?

The selection bias issue arises because successful investment strategies are often kept secret, while unsuccessful strategies become publicly known and available to researchers.

Why does the selection bias issue create problems for EMH research?

Selection bias may distort the available evidence because researchers mainly observe failed or partially successful strategies rather than profitable private strategies.

What is the lucky event issue in EMH testing?

The lucky event issue refers to the possibility that some investors outperform purely by chance rather than skill.

Why does the lucky event issue make EMH difficult to test?

Because in a large population of investors, some individuals will achieve strong performance randomly, making it difficult to distinguish genuine skill from luck.

How can weak-form EMH be tested?

Weak-form EMH can be tested by examining serial correlation between current and past stock returns to determine whether past returns help predict future returns.

What is serial correlation?

Serial correlation refers to the relationship between current stock returns and past stock returns.

What would weak-form EMH predict about serial correlation?

Weak-form EMH predicts little or no predictable relationship between past and future stock returns.

What are two important anomalies associated with weak-form EMH?

Two important anomalies are the momentum effect and the reversal effect.

What is the momentum effect?

The momentum effect is the tendency for stocks that have performed well in the recent past to continue performing well in the short to intermediate term.

Why does the momentum effect challenge weak-form EMH?

The momentum effect suggests that past returns may help predict future returns, contradicting weak-form EMH.

What is the reversal effect?

The reversal effect is the tendency for stocks that performed extremely well or poorly over long periods to reverse direction in subsequent periods.

Why does the reversal effect challenge weak-form EMH?

The reversal effect suggests that past performance may contain predictive information about future returns, which contradicts weak-form EMH.

What is the small-firm effect?

The small-firm effect is the observation that small-cap firms have historically earned higher average returns than predicted by standard asset pricing and risk models.

What is a market anomaly?

A market anomaly is evidence or a pattern in financial markets that appears inconsistent with the predictions of the Efficient Market Hypothesis (EMH).

Why does the small-firm effect challenge EMH?

The small-firm effect challenges EMH because it suggests investors may consistently earn abnormal returns by investing in small-cap firms.

Why is the small-firm effect not necessarily definitive proof that EMH is false?

The small-firm effect may reflect compensation for additional risks associated with small firms, such as lower liquidity, higher transaction costs, greater uncertainty, and reduced information availability, rather than genuine market inefficiency.

What is the neglected-firm effect?

The neglected-firm effect is the tendency for firms with low analyst coverage and limited investor attention to outperform the market.

Why does the neglected-firm effect challenge semi-strong-form EMH?

The neglected-firm effect suggests that publicly available information may be incorporated into stock prices more slowly when fewer analysts and investors follow the firm.

What is Post-Earnings-Announcement Drift (PEAD)?

Post-Earnings-Announcement Drift (PEAD) is the tendency for stock prices to continue drifting upward after positive earnings announcements and downward after negative earnings announcements.

Who first identified the PEAD anomaly?

PEAD was first identified by Ray Ball and Philip Brown in 1968.

Why does PEAD challenge semi-strong-form EMH?

PEAD challenges semi-strong-form EMH because it suggests that markets adjust gradually rather than instantaneously to publicly available earnings information.

What does PEAD suggest about investor behaviour?

PEAD suggests that investors may initially underreact to earnings announcements, causing stock prices to adjust slowly over time.

Why do market anomalies not necessarily completely disprove EMH?

Market anomalies may be difficult to exploit consistently after accounting for transaction costs, risk, taxes, and competition among investors. Some anomalies may also reflect compensation for hidden risk factors rather than true inefficiency.

Explain the £20 note analogy used in discussions of market efficiency.

The £20 note analogy suggests that obvious profit opportunities should disappear quickly because rational investors would rapidly exploit them. If an opportunity still exists, it may not be as profitable or risk-free as it initially appears.

According to the lecture, are markets perfectly efficient?

The lecture suggests that markets are highly competitive and often close to efficient, but anomalies and temporary mispricing may still exist.

Why is it difficult for professional investors to consistently outperform the market?

Professional investors compete intensely for information and profit opportunities, meaning that any advantage from superior information or insight is usually very small and difficult to sustain consistently.

Why is it difficult to distinguish investment skill from luck?

In a large population of investors, some individuals will outperform purely by chance, making it statistically difficult to determine whether strong performance reflects genuine skill or random luck.

What is the overall conclusion of the Efficient Market Hypothesis debate?

Markets appear sufficiently competitive that consistently earning abnormal returns is extremely difficult. Although some anomalies and inefficiencies may exist, they are often small, temporary, and rapidly competed away.

Compare technical analysis and fundamental analysis under EMH.

Technical analysis uses historical trading data to predict future prices and is inconsistent with weak-form EMH. Fundamental analysis uses publicly available firm information to estimate intrinsic value and is inconsistent with semi-strong-form EMH.

Does evidence of market anomalies completely disprove EMH?

Not necessarily. Many anomalies may reflect hidden risk factors, transaction costs, behavioural biases, or temporary inefficiencies that are difficult to exploit consistently. EMH may still hold approximately even if some anomalies exist.

What is the overall argument FOR the Efficient Market Hypothesis?

EMH argues that intense competition among investors causes stock prices to rapidly incorporate available information, making it extremely difficult to consistently earn abnormal returns using publicly available information.

What is the main argument AGAINST the Efficient Market Hypothesis?

Critics argue that anomalies such as momentum, PEAD, and the small-firm effect suggest that markets do not always incorporate information instantly or perfectly, allowing temporary mispricing and abnormal returns.

How do behavioural finance theories challenge EMH?

Behavioural finance argues that psychological biases and irrational investor behaviour can cause systematic mispricing and slow adjustment to information, contradicting the assumption of fully rational and efficient markets.