Market Efficiency & Behavioral Finance
Familiarity Bias
Favoring investments in companies they are familiar with.
Political cycle effect
For a given political administration, its first year and last year yield higher returns than the years in between. • Empirical Evidence Against EMH: Other Anomalies
Bubbles
A bubble occurs when the market value of the asset significantly deviates from its intrinsic value. The bubble bursts when there are no more investors willing to buy. Huge losses ensue for those who buy or sell too late. Bubbles also violate market efficiency.
Relative Wealth Concerns
Caring most about how their portfolio performs relative to their peers.
Proxy Error
Due to the lack of competitive price data, the market proxy cannot include most of the tradeable assets in the economy. • Reason Why the Market Portfolio Might Not Be Efficient
Super Bowl effect
Historical data shows that for the year following the Super Bowl, the stock market is more likely to do better if an NFC team won and worse if an AFC team won. • Empirical Evidence Against EMH: Other Anomalies
Underdiversification
Individual investors fail to diversify their portfolios adequately. They invest in stocks of companies that are in the same industry or are geographically close.
Herd Behavior
Investors actively try to follow each other's behavior. Information Cascade Effect - Investors may believe others have superior information. Thus, they copy trades, hoping to profit from information others may have. Relative Wealth Concerns - Investors may choose to follow others to avoid the risk of underperforming compared to their peers. Reputation - Investment managers may risk damaging their reputations if their actions are far different from those of their peers.
Non-Tradeable Wealth
Investors are exposed to significant risks outside their portfolio. They may choose to invest less in their respective sectors to offset the inherent exposures from their human capital. • Reason Why the Market Portfolio Might Not Be Efficient
Earnings announcement puzzle
Investors have underreacted to earnings announcements. • Empirical Evidence Against EMH: Underreaction/Overreaction Anomalies
Behavioral Biases
Investors may be subject to systematic behavioral biases and therefore hold inefficient portfolios. • Reason Why the Market Portfolio Might Not Be Efficient
Overconfidence bias
Investors often overestimate their knowledge or expertise. Men tend to be more overconfident than women.
Holding on to Losers and the Disposition Effect
Investors tend to hold on to investments that have lost value and sell investments that have increased in value. • People tend to prefer avoiding losses more than achieving gains. They refuse to "admit a mistake" by taking the loss. • Investors are more willing to take on risk in the face of possible losses. • The disposition effect has negative tax consequences.
Weak Form EMH
It is impossible to consistently attain superior profits by analyzing past returns.
Neglected firm effect
Lesser-known firms yield abnormally high returns. • Empirical Evidence Against EMH: Other Anomalies
New-Issue/IPO puzzle
Overreaction to new issues pushes up stock prices initially. • Empirical Evidence Against EMH: Underreaction/Overreaction Anomalies
Stock split effect
Returns are higher before and after the company announces the stock split. • Empirical Evidence Against EMH: Other Anomalies
Time-of-day effect
Returns are more volatile closer to the market's opening and closing hours. Also, trading volumes are higher during these times. • Empirical Evidence Against EMH: Calendar/Time Anomalies
January effect
Returns have been higher in January (and lower in December) than in other months. • Empirical Evidence Against EMH: Calendar/Time Anomalies
Monday effect
Returns have been lower on Monday (and higher on Friday) than on other days of the week. • Empirical Evidence Against EMH: Calendar/Time Anomalies
Size effect
Small-cap companies have outperformed large-cap companies on a risk-adjusted basis. • Empirical Evidence Against EMH: Other Anomalies
Alternative Risk Preferences:
Some investors focus on risk characteristics other than the volatility of their portfolio, and they may choose inefficient portfolios as a result. • Reason Why the Market Portfolio Might Not Be Efficient
Reversal effect
There is a negative serial correlation in stock prices as investors overreact to new information. • Empirical Evidence Against EMH: Underreaction/Overreaction Anomalies
Momentum effect
There is a positive serial correlation in stock prices as investors underreact to new information. • Empirical Evidence Against EMH: Underreaction/Overreaction Anomalies
Sensation Seeking
Trading activity increases with the number of speeding tickets an individual receives.
Siamese twins
Two stocks with claims to a common cash flow would be exposed to identical risks but perform differently. • Empirical Evidence Against EMH: Other Anomalies
The Efficiency of the Market Portfolio
Under the CAPM assumptions, the market portfolio is an efficient portfolio. All investors should hold the market portfolio (combined with risk-free investments). This investment advice does not depend on the quality of an investor's information or trading skill. The assumption of rational expectations is less rigid than that of homogeneous expectations. If we assume investors have rational expectations, then all investors correctly interpret and use their own information, along with information from market prices and the trades of others.
Value effect
Value stocks have consistently outperformed growth stocks. • Empirical Evidence Against EMH: Other Anomalies
Supporting Semi-Strong Form of EMH
• 3 months prior to a takeover announcement, the stock price gradually increased. At the time of announcement, stock price instantaneously jumped. After the announcement, the abnormal returns dropped to zero.
Takeover Offer
• After the initial jump in the stock price at the time of the announcement, target stocks do not appear to generate abnormal subsequent returns on average. • Stocks that are ultimately acquired tend to appreciate and have positive alphas, while stocks that are not acquired tend to depress and have negative alphas.
The market portfolio can be inefficient (and thus it is possible to beat the market) only if a significant number of investors:
• Do not have rational expectations (thus information is misinterpreted). • Care about aspects of their portfolio other than expected return and volatility (thus they are willing to hold portfolios that are mean-variance inefficient).
Systematic Trading Biases
• Holding on to Losers and the Disposition Effect • Investor Attention, Mood, and Experience • Herd Behavior The following behaviors lead investors to depart from the CAPM in systematic ways and subsequently impact the efficiency of the market.
Forms of Market Efficiency
• If something supports the stronger form of the EMH, then it also supports the weaker forms. • If something violates the weaker form of the EMH, then it also violates the stronger forms. • However, the reverse is not necessarily true.
Investor Attention, Mood, and Experience
• Individual investors tend to be influenced by attention-grabbing news or events. They buy stocks that have recently been in the news. • Sunshine has a positive effect on mood and stock returns tend to be higher on a sunny day at the stock exchange. • Major sports events have impacts on mood. A loss in the World Cup reduces the next day's stock returns in the losing country. • Investors appear to put inordinate weight on their experience compared to empirical evidence. People who grew up during a time of high stock returns are more likely to invest in stocks.
Semi-Strong-Form EMH
• It is impossible to consistently attain superior profits by analyzing public information. • Prices will adjust immediately upon the release of any public announcements (earnings, mergers, etc.). • A semi-strong-form efficient market is also weak-form efficient.
Supporting Weak Form of EMH
• Kendall found that prices followed a random walk model, i.e., past stock prices have no bearing on future prices. • Brealey, Meyers, and Allen created a scatter plot for price changes of four stocks. o No distinct pattern in the points, with the concentration of points around the origin. No bias toward any quadrants. o Autocorrelation coefficients were close to 0. • Poterba and Summers found that variance of multi-period change is approximately proportional to number of periods.
The Performance of Fund Managers
• The median mutual fund actually destroys value. • The mutual fund industry still has positive value added because skilled managers manage more money and add value to the whole industry. • On average, an investor does not profit more from investing in an actively managed mutual fund compared to investing in passive index funds. The value added by a fund manager is offset by the mutual fund fees. • Superior past performance of funds was not a good predictor of future ability to outperform the market
Strong-Form EMH
• There are only lucky and unlucky investors. No one (not even company insiders) can consistently attain superior profits. • Passive strategy is the best. • A strong-form efficient market is also semistrong and weak-form efficient.
Supporting Strong Form of EMH
• Top performing fund managers in one year only have a 50% chance to beat their reference index the following year. • The performance of actively managed mutual funds from 1971 to 2013 only beat the Wilshire 5000 index 40% of the time.
The Behavior of Individual Investors
• Underdiversification • Excessive Trading and Overconfidence The following behaviors do not impact the efficiency of the market and have no effect on market prices or returns.
Stock Recommendation
• When a stock recommendation is given at the same time that news about the stock is released, the initial stock price reaction appears correct. The stock price increases in the beginning, then it flattens out. • When a stock recommendation is given without news, the stock price seems to overreact. The stock price surges the following day, then it falls compared to the market