FIN3244 Chapter 6

Mean reversion

Stocks with low returns today tend to have high returns in the future, and vice versa.

Case: Foreign Exchange Rates

- Could you make a bundle if you could predict FX rates? Of course. - EMH predicts, then, that FX rates should be unpredictable. - Oddly enough, that's exactly what empirical tests show—FX rates are not very predictable.

Evidence in Favor of Market Efficiency: Do Stock Prices Reflect Publicly Available Information as the EMH predicts they will?

- If info is already publicly available, a positive announcement about a company will not, on average, raise the price of its stock bc this info is already reflected in the stock price. - Early empirical evidence confirms: favorable earnings announcements or announcements of stock splits don't, on average, cause stock prices to rise.

Raj Rajaratnam

- In the mid-2000s, he made millions of dollars for himself & his investors by investing in firms on which he allegedly received inside info. - His strategy shows that you can profit from info. that the market doesn't have. - But that strategy landed him in jail for insider trading.

Implication for Investing: Do stock prices always rise when there is good news?

- NO. In an efficient market, stock prices will respond to announcements only when the info being announced is new & unexpected. - So, if good news was expected (or as good as expected), there will be no stock price response. - And, if good news was unexpected (or not as good as expected), there will be a stock price response.

Evidence in Favor of Market Efficiency: Performance of Investment Analysts and Mutual Funds shouldn't be able to consistently beat the market

- The "Investment Dartboard" often beats investment managers. - Mutual funds not only don't outperform the market on average, but when they are separated into groups according to whether they had the highest or lowest profits in a chosen period, the mutual funds that did well in the first period don't beat the market in the 2nd period. - Investment strategies using inside info. is the only "proven method" to beat the market. In the U.S., it's illegal to trade on such info., but that isn't true in all countries.

Evidence in Favor of Market Efficiency: Technical Analysis

- The EMH suggests that it's a waste of time - The simplest way to understand why is to use the random-walk result that holds that past stock price data cannot help predict changes - Therefore, it relies on such data to produce its forecasts, cannot successfully predict changes in stock prices

Rationale Behind the Hypothesis

- When an unexploited profit opportunity arises on a security, investors will rush to buy until the price rises to the point that the returns are normal again. - In an efficient market, all unexploited profit opportunities will be eliminated. - Not every investor need be aware of every security and situation. - As long as a few keep their eyes open for unexploited profit opportunities, they will eliminate the profit opportunities that appear bc in so doing, they make a profit.

Implications for Investing; Should you be skeptical of hot tips?

- YES. The EMH indicates that you should be skeptical of hot tips since, if the stock market is efficient, it has already priced the hot tip stock so that its expected return will equal the equilibrium return. - Thus, the hot tip isn't particularly valuable & won't enable you to earn an abnormally high return. - As soon as the info hits the street, the unexploited profit opportunity it creates will be quickly eliminated. - The stock's price will already reflect the info, & you should expect to realize only the equilibrium return.

The Practicing Manager: Implications for Investing

1. How valuable are published reports by investment advisors? 2. Should you be skeptical of hot tips? 3. Do stock prices always rise when there is good news? 4. Efficient Markets prescription for investor

Evidence on Efficient Market Hypothesis: Favorable evidence

1. Investment analysts and mutual funds don't beat the market 2. Stock prices reflect publicly available info: anticipated announcements don't affect stock price 3. Technical analysis does not outperform market

Evidence on Efficient Market Hypothesis: Some Unfavorable Evidence

1. Small-firm effect: small firms have abnormally high returns 2. January effect 3. Market overreaction 4. Excessive volatility 5. Mean reversion 6. New information isn't always immediately incorporated into stock prices

Efficient Market Hypothesis

Financial economists state it simply: A security's price fully reflects all available info. in an efficient market.

Implications for Investing: Efficient Markets prescription for investor

Investors shouldn't try to outguess the market by constantly buying & selling securities. - This process does nothing but incur commissions costs on each trade. - Instead, the investor should pursue a "buy and hold" strategy - This will lead to the same returns, on average, but the investor's net profits will be higher bc fewer brokerage commissions will have to be paid. - It's frequently a sensible strategy for a small investor, whose costs of managing a portfolio may be high relative to its size, to buy into a mutual fund rather than individual stocks. - Bc the EMH indicates that no mutual fund can consistently outperform the market, an investor shouldn't buy into one that has high management fees or that pays sales commissions to brokers but rather should purchase a no-load (commission-free) mutual fund that has low management fees.

stock splits

a division of a share of stock into multiple shares, which is usually followed by higher earnings

unexploited profit opportunity

on average, ppl would be earning more than they should, given the characteristics of that security

Buy and Hold Strategy

purchase stocks and hold them for long periods of time

Evidence on Efficient Market Hypothesis

reasonable starting point but not whole story

small-firm effect

small firms have abnormally high returns

Market overreaction

stock prices overreact to news announcements - Investors may purchase a stock after bad earnings reports then sell it a couple of weeks later after it has gone back to a normal level

January Effect

tendency for small stocks to have large returns in January

Technical Analysis

the study past stock price data, searching for patterns such as trends and regular cycles, suggesting rules for when to buy and sell stocks