week 21 Market Efficiency and Behavioral Finance Notes

Efficient Markets

• Random Walk Hypothesis: Stock price movements are largely unpredictable.
• Efficient Market: Rapidly incorporates new information.
• Efficient Markets Hypothesis (EMH): Stock prices rapidly incorporate new information; investors can't consistently earn abnormal returns.
• Abnormal Return (Alpha) = Actual Return - Expected Return
  *Example of Expected return:
  *E(r) = 2\% + 1.0(10\% – 2\%) = 10\%.
  *Suppose the stock actually earned a 12\%$ return:
  *Abnormal return = 12\% – 10\% = 2\%$$.
• Levels of EMH:
  • Weak Form: Past data is useless.
  • Semi-Strong Form: Public information can't be used for abnormal returns.
  • Strong Form: No information (public or private) allows abnormal returns.
• Arbitrage: Simultaneously buying and selling the same asset at different prices for risk-free profit.

Market Anomalies

• Market Anomalies: Patterns inconsistent with EMH.
  • Calendar Effects: Returns tied to time of year/week (e.g., January effect).
  • Small-Firm Effect: Small firms may have higher returns.
  • Post Earnings Announcement Drift (Momentum): Price adjustments continue after announcements.
  • Momentum: Stocks that have gone up recently tend to keep going up
  • Value Effect: Low P/E or market-to-book ratio stocks outperform high stocks.

Possible Explanations of Market Anomalies

• Higher returns compensate for risk.
• Patterns appear by chance.
• Behavioral Finance: Systematic mistakes create inefficiencies.

Behavioral Finance

• Overconfidence: Underestimate risks.
• Self-Attribution Bias: Taking credit for successes, blaming failures on external factors.
• Loss Aversion: Risk-averse with gains, risk-seeking with losses.
• Representativeness: Difficulty thinking about randomness.
  • Overreaction: Overestimating trend continuation.
  • Underreaction: Underreacting to new information.
• Narrow Framing: Analyzing situations in isolation.
• Belief Perseverance: Ignoring conflicting information.
• Anchoring: Over-weighting available information.
• Familiarity Bias: Buying familiar stocks regardless of their quality.

Implications of Behavioral Finance for Security Analysis

• Identify psychological factors causing systematic mistakes.
• Determine if these mistakes predict stock price patterns.
• Some investors' mistakes create profit opportunities for others.