FIN 320 Chapter 11 & 12 Market Efficiency

What does EMH stand for?

efficient market hypothesis

The Performance of Mutual Funds Show

they don't provide positive abnormal returns

4 details of hedge funds

1. A hedge fund is an investment fund that pools capital from accredited individuals or institutional investors 2. They are less regulated than mutual funds and have to provide much less information about portfolio composition to the public 3. They typically have no more than 100 investors and do not advertise to the public 4. These features allow the funds to pursue more aggressive investment strategies than mutual funds

2 details of mental accounting

1. A person views various sources of money as being different from others 2. Where the money on your account came from should not affect your decision-making regarding future investments ex. Money earned at a job may be viewed differently than money from an inheritance

3 Adjustments to New Information

1. Efficient market: instantaneous adjustment so that P1 = V1 2. Underreaction 3. Overreaction

3 Details of Liquidity (neglected firm) effect

1. Firms not widely followed by analysts earn higher returns in many datasets. 2. May be compensation for higher risk of the firms 3. The returns may disappear after trading costs

2 Details of Asset Growth Effect.

1. Growth rate in a firm's balance sheet total assets is in many cases a strong predictor of future stock returns. 2. Could also be related to risk

6 Details of Whether Hedge Funds or Mutual Funds Provide Better Returns

1. Hedge funds only limited public information is available 2. Many hedge funds invest in illiquid assets -> May imply an unrealistically smooth return series -> Alphas and Sharpe ratios may be upward biased 3. Hedge funds often have high tail-risk (there are rare but significant negative events) 4. There is evidence of accounting-based return smoothing related to illiquid assets 5. The fees of hedge funds are high and they also impose restrictions on investors 6. Assets under management has grown a lot, maybe the "smart money" is there, but it's harder to spot it these days

2 Details of The Performance of Finance Professionals

1. If markets are completely efficient, even professional investors should not be able to obtain abnormal returns 2. Grossman-Stiglitz paradox suggests that there should be enough inefficiency to create profits for some investors

3 Details of Grossman-Stiglitz Paradox

1. If markets are truly efficient and reflect all available private information perfectly since there are no incentives to collect private information because all information can be obtained from publicly available signals (i.e., the market price) 2. But, if all market participants stopped doing research/gathering information about future stock values prices would not reveal private information and markets would no longer be efficient 3. Thus, there is an optimal level of inefficiency in the markets.

3 Details of the Adjustment to New Information Under EMH

1. If the markets are efficient, stock prices should immediately adjust to new information, once it becomes available 2. Suppose that P0 = current market price of a security V0 = current fair price of a security P0 = V0 3. There is a news announcement (e.g., earnings announcement). P1 = new market price V1 = new fair price (intrinsic value) Under EMH, P1=V1 immediately after the announcement

2 ways you can beat the market in the long run under EMH

1. If you are very lucky 2. If you take more than average systematic risk

2 details of disposition effect

1. Investors are more likely to sell their winners than sell their losers 2. The problem is that they may hang on to the losing stocks much longer than would be optimal e.g. because of taxes

7 examples of historically documented market anomalies

1. January Effect 2. Liquidity effect 3. Size Effect 4. Book-to-market effect 5. Momentum Effect 6. Post-Earnings Announcement Drift 7. Asset Growth Effect

5 Details of Gender Relation to Investment Performance

1. Neither group shows any stock picking skills on average 2. They document that men trade 45% more than women 3. Trading reduces men's net returns by 2.65 percentage points a year as opposed to 1.72 percentage points for women. 4. On average men lose relative to women, because they trade more 5. Psychological research indicates that men are systematically more overconfident than women, which can explain the difference

5 details of overconfidence

1. One of the most robust findings in the psychology of judgement is that people are overconfident 2. People overestimate the reliability of their knowledge and abilities ex. Psychologists, physicians, engineers, attorneys, investment bankers, security analysts... People also tend to overestimate their abilities 3. Putting too much weight on self-collected information and think that they can outperform the market even if the average person can't 4. When you make gains it's skill, when you make losses it's bad luck... 5. If people think they can outperform the market when they really can't, it can result in excessive transaction costs and undiversified portfolios

3 Market Anomalies

1. Over the years, several market anomalies that appear to violate the EMH have been documented 2. Many anomalies that have been documented have disappeared over time - they may be traded away 3. Even if you observe an anomaly, you can't always make profits based on it e.g. because of transaction costs

2 details of loss aversion

1. People often feel the pain of loss more than the joy of gains ex. recall investment portfolio declines more vividly than gains 2. If an investment is perceived at being at a loss, people may want to take more risk to break even

2 details of self-attribution bias

1. People tend to attribute successful outcomes to their own skill but blame unsuccessful outcomes on bad luck 2. There's evidence that investors that (are lucky enough to) beat the market start trading more and this leads to poor net performance in the future.

4 reasons you can make a lot of money based on market efficiency

1. People trade based on available information 2. Prices change according to trading 3. Prices reflect all available information 4. You can't make abnormal profits by using information that is already reflected in prices

2 Details of Underrreaction

1. Prices respond with a lag. 2. If you can predict the underreaction, market prices can be predicted.

4 Details of Event Studies

1. Sometimes market reactions to specific events can reveal information that is otherwise hard to quantify 2. The idea: To measure what impact an event has on a company's market value, look at the abnormal stock return following the event 3. Abnormal return = realized return minus expected return 4. Expected return can be the market return or a return based on an asset pricing model

5 details of efficient market hypothesis (EMH)

1. States that security prices fully reflect all available information about securities at all times. 2. There is an instantaneous adjustment of prices to new information. 3. Market efficiency is based on the idea that arbitrageurs trade based on any observed inefficiencies and make them disappear 4. Markets are efficient relative to a given information set if abnormal returns cannot be made using that information 5. An abnormal return means excess return after you account for risk factors (e.g. alpha assuming that the asset pricing model is correct)

3 Details of the Implications of the Efficient Market Hypothesis

1. Stock price changes are random (over short intervals), i.e. you can't forecast them using currently available information because prices still reflect risk, so that risky stocks earn higher returns than less risky stocks 2. The market is right, on average therefore you can't really beat the market in the long run: 3. You can't benefit from market analysis

2 Details of January Effect

1. Stocks (especially small stocks) earn higher returns in January 2. Related to tax-loss selling before the turn of the year

3 Details of Post-Earnings Announcement Drift.

1. Stocks with positive (negative) earnings surprises earn positive (negative) average abnormal returns for several weeks after the announcement. 2. No instantaneous adjustment to information 3. Perhaps due to trading costs or arbitrage costs

6 Details of No Evidence of Alpha

1. The evidence strongly suggests that the average fund does not outperform the market 2. There is some evidence that the good/bad performance of individual funds persists over time 3. However, the persistence seems to be much stronger for poorly performing funds than for well-performing funds 4. Most outperformance and persistence can be explained by multifactor models 5. Also, many of the funds that show positive alphas before fees show negative alphas after fees 6. The bottom line: Some actively managed funds outperform the market index, but almost all funds still underperform mechanical strategies.

4 Details of Survivorship Bias

1. The graph on the previous slide only considered funds that have 10 years of continuous records 2. The problem is that typically successful funds stay alive and funds with bad returns are more likely to be liquidated or merged with others 3. After accounting for this survivorship bias, the average performance is negative compared to the market 4. The lesson: It's important to also look at the "graveyard" when you evaluate the performance of fund management firms

6 Details of Whether Analyst Recommendations Add Value

1. The stocks most highly rated by analysts outperform a passive market strategy and produce positive alphas 2. However, the strategy involves excessive portfolio rebalancing when transaction costs are taken into account, the abnormal profits disappear 3. Also, in a later article, the same researchers studied what happened during the dot-com bubble between 2000-2001 4. The stocks least favorably recommended by analysts earned an annualized market-adjusted return of 49%. 5. The stocks most highly recommended earned -31% 6. Good to keep in mind: Providing recommendations is just one part of an analyst's job, other information that they provide in their reports may still be useful for different purposes.

2 details of house money effect

1. The tendency for investors to take more and greater risks when investing with profits they have already made 2. One form of mental accounting Ex. Analogy: Think about the average person who wins in the casino.

2 details of familiarity bias

1. The tendency to invest in familiar stock/assets ex. explain why people often invest in companies located in their home city 2. Can result in underdiversification

2 details of people trading too much

1. They lose money because of transaction costs 2. The people who trade more do not on average perform better than those who trade less

3 Forms of Market Efficiency

1. Weak form 2. Semistrong form 3. Strong form

2 scenarios if the market sometimes underreacts and sometimes overreacts so that you can't predict it

1. You cannot take advantage of over/underreaction. 2. Markets are efficient!

2 Details of Overreaction

1. market prices "overshoot" and then adjust to the new fair price after a while. 2. If you can predict the overreaction, market prices can be predicted.

6 Well-Known Behavioral Biases that Affect Investors

1. self-attribution bias 2. disposition effect 3. mental accounting 4. familiarity bias 5. loss aversion 6. house money effect

Size Effect.

Companies with small market capitalization earn higher returns.

semistrong form implications

If the semistrong form holds, fundamental analysis, (such as trading strategies that use financial statement information to forecast returns), is useless and does not lead to abnormal returns

optimal level of inefficiency

Expected marginal benefit of information = Marginal cost of gathering information

strong form implications

If the strong form holds, nobody can make abnormal returns no matter what information they use. Even the (illegal) use of insider information does not lead to abnormal profits.

weak form implications

If the weak form holds, technical analysis, (such as trading rules which aim to forecast future returns by using past trading data), is useless and does not lead to abnormal returns

IQ and Investment Performance

High IQ investors are better stock pickers and market-timers, and are also less likely to suffer from certain behavioral biases

regret avoidance

Investors are reluctant to bear losses due to their unconventional decisions

representativeness bias

Investors disregard sample size when forming views about the future from the past.

Do Investor Characteristics Matter?

Often it's the case that these better-performing investors do not suffer from behavioral investment mistakes, such as excessive trading, as much as others

If you observe under/overreaction regarding specific events, does it indicate that the EMH is violated?

Only if you can predict when the prices will overreact and/or underreact and trade profitably based on the information

Momentum Effect.

Stocks that have performed the best during the past 9-12 months continue to perform well during the next month and vice versa.

If markets are as efficient as they seem, why do we see so many individuals who try to outperform it with active trading?

The answer may lie in human psychology through biases and traits that are shared by most people

B/M ratio

The book-to-market ratio compares a company's book value to its market value.

Back-fill bias

The distortion in index or peer group data which results when returns are reported to a database only after they are known to be good returns.

Weak form

The information set reflected in current prices contains all past trading data (historical returns, trading volumes...)

Semistrong form

The information set reflected in current prices contains past trading data and all other publicly available information (balance sheet information, quality of a firm's management, patents held, etc...)

: Strong form

The information set reflected in current prices includes all possible information, both public and private

Why Should Markets Be Efficient?

There is a strong incentive to predict stock price movements correctly you can make a lot of money based on it

Book-to-Market Effect.

Value stocks (stocks with high B/M ratio) earn higher returns.

conservatism bias

investors are too slow (too conservative) in updating their beliefs in response to recent evidence

multifactor models

models of security returns that respond to several systematic factors

Detecting violations of market efficiency is not

straightforward

high water mark

the previous value of a portfolio that must be reattained before a hedge fund can charge incentive fees

Arbitrage

the purchase of securities in one market for immediate resale in another to profit from a price discrepancy