Chapter 10 Efficient Markets

Active money management

can test efficiency of market by comparing performance of professionally managed funds with performance of market index

Regret avoidance

individuals who make decisions that turn out badly have more regret when that decision was more unconventional

Semistrong form efficient market

publicly available information does not predict future retruns

Abnormal return

return in excess of that earned by other investments with same risk

Prospect theory

risk seeking with respect to losses

What is regret avoidance consistent with? (2)

size premium and long term reversals

According to EMH, what is the only way to get higher returns?

taking on more risk

Media content and sentiment

text analysis of NY times counting the number of positive and negative words each day

What does the medium term momentum strategy indicate?

that the market is not weak form efficient

If a market is semistrong form efficient, what should mutual fund managers earn?

the same returns to those of the average investor in the market

3 behavioral biases

1) regret avoidance 2) affect 3) prospect theory

4 ways to measure risk of strategy

1) standard deviation 2) downside risk 3) market beta 4) multifactor model

Abnormal return formula

Asset return - market return

Market efficiency paradox

If markets are perfectly efficient, it is not profitable to acquire information and seek superior investments, but if nobody acquires and trades on information, markets cannot be efficient.

Affect

a feeling of good or bad that investors may attach to investment in a stock

Event studies

assess the impact of an event on asset prices and returns

Market efficiency

degree to which stock prices reflect all available information

Medium term momentum strategy

form a portfolio of stock winners that performed very well (2 moths - 1 year) in recent past and a portfolio of stock losers

Efficient market hypothesis

major financial markets reflect all relevant information at all times

What does the LT reversal strategy indicate?

markets are not weak form efficient

Weak form efficient market

past prices, trading volume, and short interest do not predict future returns

Conservatism

people tend to be too slow in updating their beliefs in response to new evidence

Why do traders tend to increase risk throughout the day?

they've experience losses earlier in the day

Random walk (2)

1) day to day stock price changes are uncorrelated 2) expected return on a stock is the same every day regardless of what happened to the stock price in previous days

Long term reversal strategy (2)

1) form a portfolio of stock winners (1-6 years) and losers 2) losers outperform winners over the next year

Evidence against market efficiency (5)

1) market crashes and bubbles 2) volume of trading too high 3) volatility of returns too high: dividends not volatile 4) existence of too many mutual funds 5) return anomalies

3 errors in information processing

1) overconfidence 2) conservatism 3) sample size neglect and representativeness

2 Event study results

1) prices adjust quickly following public news announcements 2) prices drift slowly prior to public news announcement, perhaps due to trading on private information

3 characteristics that attract investors to firms

1) reputations for socially responsible practices 2) attractive working conditions 3) produce popular products

Technical analysis (3)

1) searching for recurring and predictable patterns in prices 2) attempting to take advantage of slow adjustments to changes in fundamentals 3) used in weak form efficient

3 implications of market efficiency

1) security selection less important 2) market timing not possible 3) little role for professional money managers

3 characteristics of behavioral finance

1) some anomalies are consistent in behavioral "irrationalities" 2) individuals don't always process info correctly 3) individuals make inconsistent or systematically suboptimal decisions

Evidence for semistrong form market efficiency (3)

1) stock prices appear to move randomly 2) new public information appears to be quickly incorporated into prices 3) professional money managers do not consistently beat the market

Random walk and market efficiency (2)

1) there is no useful information in past price changes 2) if prices reflect all relevant information, then prices change only when "new" information arrives

Fundamental analysis (3)

1) using economic and accounting information to value securities 2) studying income statements, industry news, and the macro economy 3) used in semistrong

Beat the market

consistently earning a positive abnormal return

Downside risk

does the strategy sometimes perform very poorly?

Why will insider trading not "beat the market" in strong form efficiency?

evidence suggests prices move before public announcement

What is affect consistent with?

high average returns of "sin" stocks and low average returns of prominent admired companies

Anomalies

investment strategies which seem to earn high returns without being very risky

Strong form efficient market

no information of any kind, public or private, is useful for predicting future returns

Efficient market

one where information is quickly and accurately reflected in prices

Sample size neglect and representativeness

people commonly act as if a small sample is just as representative of the population as a large sample

Overconfidence

people tend to overestimate the precision of their beliefs and the strength of their abilities