Chapter 7 Are Financial Markets Efficient?
If we are investing in a more efficient/less efficient market, in what ways should we invest? (2)
1) Less -> active 2) More -> passive
What are the 3 versions of the efficient market hypothesis?
1) Weak 2) Semi-strong 3) Strong
What does human behavior in markets suggest that real people do? (3)
1) have limited info processing capabilities 2) exhibit systematic bias in processing information 3) are prone to making mistakes
4 facts of evidence in favor of emh
1) investment analysts and mutual funds don't beat the market 2) stock prices reflect publicly available info 3) stock prices close to random walk 4) technical analysis does not outperform market
3 Behavioral issues in finance
1) overconfidence 2) loss aversion/prospect theory 3) Framing
2 implications of the loss aversion/prospect theory?
1) people tend to sell "winners" too soon 2) hold "losers" too long
3 conclusions from market efficiencies?
1) pricing irregularities do exist 2) predictable patterns exist 3) there is no guarantee they'll continue nor that you will be able to spot them and take advantage of them
What are the 2 assumptions of efficient markets?
1) rational investors 2) "perfect" markets and complete information
Seasonal effects (2)
1) returns were significantly higher at the turn of the month 2) returns were higher the day before a holiday
Why do investors have the incentive to sell stocks before the end of the year in december? (2)
1) take capital losses on their tax return 2) reduce their tax liability
What does overconfidence cause investors to do? (2)
1) trade too much 2) causes them to be too certain of their opinions
Efficient Market Hypothesis
If markets are efficient, anticipated events have already been discounted in asset prices
Do we want to invest in a more or less efficient market?
More efficient market, it has less risk
Weak form efficiency
Prices reflect all past market information such as price and volume
Semistrong form efficiency
Prices reflect all publicly available information including trading information, annual reports, press releases, etc.
What happens in efficient markets when there is an unanticipated "unfavorable" event?
Prices would adjust down very quickly at the time of the announcement and stabilize
What happens in inefficient markets when there is an unanticipated "unfavorable" event?
Prices would drift downward for some time following the event
What does the weak form efficiency imply?
That technical analysis will not lead to abnormal returns
What happens if weak form efficiency is true?
Then investors cannot earn abnormal returns by trading on market information
What happens if semistrong form efficiency is true?
Then investors cannot earn abnormal returns by trading on public information
Neurofinance
attempts to understand behavior by examining the physiological processes in the human brain when exposed to financial risk
Framing
decisions depend on the way a situation is framed
What is the issue of behavioral issues in finance?
effect of psychological traits of investors on financial decision making
How efficient are equity markets?
equity prices adjust quickly upon receiving new information and are reasonably efficient
Why does the market not appear to be strong form efficient?
insiders can earn abnormal returns
Loss aversion/prospect theory
losses loom larger than gains so less risk is taken when facing gains and more risk taken when facing losses
Anomalies
market and behavioral imperfections
Purpose of informed trading strategies
minimize price impact to maximize profits
Strong form efficiency
prices reflect all information, including public and private
Weather effect
returns were positively correlated with sunshine
The Weekend (Monday) Effect
tendency for returns to be negative on mondays and positive on the other days of the week with large and positive returns on fridays
The January Effect
tendency of stock prices to experience an abnormal positive return in the month of January that is predictable
What does semistrong form efficiency imply?
that fundamental analysis will not lead to abnormal returns
What happens if strong form efficiency is true?
then investors cannot earn abnormal returns regardless of the information they possess
Why do investors repurchase their stocks in January?
they can drive up their prices and produce abnormally high returns
What is the rationale behind the EMH?
when an unexploited profit opportunity arises, investors will rush to buy until the price rises to the point that the returns are normal again
When should you trade aggressively?
when private information will soon become common knowledge or when other traders will act on the same information
When should you trade slowly?
when their private information will not soon become common knowledge
