FINC 335 Investments: The Efficient Market Hypothesis TOPIC 8

FINC 335: Investments

The Efficient Market Hypothesis

Course Details

  • Instructor: An Qin

  • Institution: Loyola University Chicago

  • Semester: Spring 2026

Review Topics

  • Capital Asset Pricing Model (CAPM)

    • Assumptions of CAPM

    • The Market Portfolio

    • Security Market Line (SML)

    • Applications of CAPM

    • Stock Selection

    • Investment Strategies

    • Capital Budgeting

    • Multi-Factor Models

    • Arbitrage Pricing Theory (APT)

Agenda

  • Efficient Market Hypothesis (EMH)

  • Three Forms of Market Efficiency

  • Market Anomalies

Efficient Market Hypothesis (EMH)

Definition

  • Market Efficiency: Prices fully reflect all available information.

  • If markets were not efficient, investors would trade to exploit inefficiencies.

  • Mechanisms of efficiency: Supply, demand, and competition.

Misconceptions Regarding EMH

Misconception 1: Social Desirability

  • Clarification: Efficiency does not mean market prices are socially desirable.

    • It indicates that market prices effectively incorporate investors’ information.

Misconception 2: Price Reactions to Good News

  • Scenario:

    • Assume earnings were expected to increase by 100 $mm.

    • Actual earnings increase by 50 $mm.

    • This is good news, but not meeting expectations; stock price may decrease.

Misconception 3: Consistent Outperformance

  • Clarification: Efficiency does not imply that no one can outperform the market.

    • Skepticism lies in consistency in outperforming on a risk-adjusted basis after accounting for transaction costs.

Implications of Market Efficiency

Price Reactions to Information

  • Timeliness: Prices should react quickly and accurately to new market information.

  • Price changes should be characterized as random and unpredictable: E( ext{Price Change}) = E( ext{Price Change}) - 0.

Intraday Reactions to News

  • Stock prices react quickly (within minutes) to news reports.

    • Example: Intraday response to reports from CNBC.

    • After-hours Trading: Stocks recommended on shows (e.g., “Mad Money” with Jim Cramer) exhibit significantly higher returns and trading volume after airing.

Three Forms of Market Efficiency

  • Types:

    • Weak Form Efficiency

    • Semi-strong Form Efficiency

    • Strong Form Efficiency

Weak Form Efficiency

  • Definition: Prices reflect all information contained in historical price data.

  • Implication: Trends in past prices are part of this information set.

    • Above-average return today does not predict above or below-average return tomorrow.

  • Example: If returns are above average this year, it does not imply above-average returns next year.

    • If it did, investors would buy, increasing price, which brings expected return back to average.

Random Walk Hypothesis

  • Postulation: Stock price changes follow a random walk:

    • P{t+1} = Pt + e_{t+1}.

  • Implications:

    • Returns are random and unpredictable (serially uncorrelated).

    • Stock prices are always at fair levels (fundamental value).

    • Stock prices react immediately to news.

  • Empirical Evidence: Stock prices exhibit characteristics of a random walk, suggesting unpredictibility of returns.

Stock Returns and Random Walks

  • Daily Stock Returns - Google (2012):

    • Example of stock return data and comparison to randomly generated numbers shown in trends over dates in 2012.

Momentum Effect

  • Definition: Poorly performing stocks and well-performing stocks tend to continue their abnormal performance over short horizons.

Reversal Effect

  • Definition: Poorly performing stocks and well-performing stocks may experience price reversals in subsequent long horizons.

Semi-strong Form Efficiency

  • Definition: Prices incorporate all publicly available information.

    • Examples of public data:

    • Earnings announcements

    • Credit rating changes

    • Mergers and acquisitions

    • Stock splits

    • Dividend policy changes

  • Empirical Evidence: Earnings drift is a notable challenge to semi-strong efficiency.

Other Exceptions (Anomalies) to Semi-strong EMH

The Small-Firm-in-January Effect

  • Description: Observations regarding average annual returns for small versus large firms across size deciles.

    • Returns data from 1926-2008 reflecting size-based portfolio performance.

Book-to-Market Ratios

  • Description: Average returns as a function of book-to-market ratio, analyzed from 1926-2008.

Strong Form Efficiency

  • Definition: Prices reflect all information, including public and private data.

  • Challenge: Evidence shows corporate insiders earning abnormal returns, undermining strong form efficiency.

EMH Conclusions

Difficulties in Testing EMH

  • Evidence Supporting EMH:

    • Prices react quickly to new information.

    • No serial correlation exists in individual daily stock returns.

    • Most investment managers do not achieve market-beating performance consistently.

    • Anomalies are often inconsistent across time, potentially due to data mining.

Evidence Against EMH

  • Market Anomalies: Observable irregularities contradicting EMH.

  • Limits of Arbitrage: Involves significant risks, limiting effectiveness.

  • Implications for Securities Analysis:

    • Raises the question of the value of securities analysis.

    • Do mutual fund managers generate abnormal returns?

    • Generally, evidence suggests they do not outperform the market on average.