Reading 41: Market Efficiency

Book 2: Equity Investments

Informationally Efficient Capital Market

the current price of a security reflects all available information about that security

What investment strategy should you use when a market is effiient?

passive investment strategy

When should you use an active investment strategy?

when the market is inefficient

What is the measurement for market efficiency?

the time it takes for trading activity to cause information to be reflected in security prices

Difference between market value and intrinsic value?

market value ==> current price

intrinsic value ==> the value that a rational investor with full knowledge would pay for a security

Factors that affect a market’s efficiency

number of participants

availability of information

impediments of trading

transaction and information costs

True or False: short selling proves market efficiency

true

True or False: arbitrage improves market efficiency

true.

the mispricings will correct themselves and then return to the intrinsic value

How are Transaction and Information Costs relevant?

if the costs of obtaining information > than the profits of obtaining information, then markets will remain inefficient

What is the Weak-Form of EMH?

security prices reflect all current available market date

• past price and volume history are fully reflected in current prices

How can someone beat the market if it is Weak-Form?

fundamental analysis

• technical analysis will not work

What is the Semi-Strong Form of the EMH?

current prices reflect all publicly available information

• prices include all past security price history and public information

How do you beat the Semi-Strong Form?

trading on inside information

• fundamental or technical analysis will not work

What is the Strong-Form of the EMH?

prices fully reflect all public and nonpublic information

How do you beat the Strong-Form of EMH?

you don’t

What’s another phrase for risk-adjusted returns?

abnormal returns

Technical Analysis

earn positive abnormal returns using historical price and volume data

Does evidence show that technical analysis beats EMH?

no

How do you test the Semi-Strong Form?

event study

Event Study

examine abnormal returns before and after the release of new information

earnings print, change in dividend, etc.

Where has technical analysis been successful?

EM

If the market is in semistrong form, how can participants beat the market?

passive portfolio management

What is the point of PMs if they consistently underperform the market?

diversification services, asset allocation, tax services

Market Anomaly

an event that deviates from the norm and that would indicate a rejection of the EMH

Data Snooping/Data Mining

investigating data until a statistically significant relation is found

How do you avoid data snooping?

examine if there is an economic relationship between the variable that generated abnormal returns and the stock returns and see if the relationship is persistent over time

January Effect

stock returns are greater than they are the rest of the year

What are possible explanations for the January Effect

Tax Loss Selling

Window Dressing

Tax Loss Selling

investors sell losing positions in December to realize a loss for tax purposes and then repurchase them in January

Window Dressing

PMs sell risky stocks in Dec to remove them from their year-end statements and then repurchase them in Jan

Does the January Effect hold statistical truth?

no, evidence shows that overtime it doesn’t exist

Turn of the Month Effect

returns are higher in the days around the months end

Day of the Week Effect

average Monday returns are negative

Weekend Effect

returns are higher on Friday but then lower on Monday

Holiday Effect

pre-holiday returns are higher

Overreaction Effect

firms with poor returns over 3- and 5-years have better subsequent returns that firms who had great returns over the same time interval

Momentum Effect

high short-term returns are continued by high returns

Which form of EMH does the Overreaction Effect and Momentum Effect violate?

Weak-Form

it is possible to generate abnormal returns based on historical price and volume history

Size-Effect

small-cap stocks outperform large-cap stocks

Value Effect

value stocks outperform growth stocks

Which form of EMH does the Value Effect violate?

semistrong form

if you conduct fundamental analysis, you can beat the market

Closed-End Investment Funds

shares of closed-end funds sometimes trade at prices well below their NAV share value

What is the caveat to the Closed-End Investment Fund Anomaly?

transaction costs eliminate any abnormal returns

Earnings Surprise Anomaly

portion of announced earnings that was not expected by the market generates positive risk-adjusted returns post-announcement

IPO Anomaly

IPOs are typically underpriced but then precede to generate below average returns over the long-run

investors overreacting

True or False: EMH requires that investors are rationally behaving.

false

there is no requirement that investors are rational, utility maximizing participants

Loss Aversion

the tendency for people to be more risk averse when facing potential losses than risk-seeking when facing potential gains

Investor Overconfidence

investors overestimate their abilities to analyze security information

Herding

investors acting in concert on the same side of the market by mimicking others’ actions

Information Cascade

investors mimicking the decisions of others and ignoring their own private information