Market Efficiency and Behavioral Finance

12

"Limits to arbitrage" implies that it may not be possible to realize some arbitrage opportunities that exist "on paper". This is an important concept that is foundational for the existence of behavioral effects. For instance, consider a stock that cannot be shorted (this may be because of low institutional ownership). If irrational investors are overly-optimistic about the stock, they can push its price above the fundamental value. Because the stock cannot be shorted, rational arbitrageurs cannot sell it short to reduce the price to the fundamental value. If they were able to short the stock, they would do so until the stock reached its fundamental value and the behavioral effect would disappear.

13

(c) The P/E ratio is public information so this observation would provide possible evidence against thesemi-strong form of the efficient market theory. This may not be a violation of the semi-strong form ofthe efficient market hypothesis for the following reason. The fact that the P/E ratio forecasts returnsimplies that the expected market return is time-varying and this variable captures that time variation. Ifwe knew that the correct model of market-level returns are that they are constant, then this wouldimply a violation of the EMH. Since we don't know whether this is the correct model (i.e., there may beperfectly rational reasons for expected returns to be time varying such as fluctuations with the businesscycle). This is a classic joint hypothesis problem - we don't know whether this observation about P/E isreally evidence of market inefficiencies or that the model we had in mind (constant expected returns) iswrong

effects prices/trading

Additionally, there have been instances where the Law of One Price has been violated due to investor behavior. One example is with twin shares such as Royal Dutch and Shell Transport, which are essentially two different stocks that represent the same underlying company. These shares should theoretically trade at the same price, but they have historically traded at different prices due to factors such as investor sentiment and liquidity. Another example is with internet carve-outs, such as Palm and 3Com, which are companies that were spun off from their parent companies. In some cases, the market may misprice these stocks due to confusion about their relationship with the parent company.

18

An anomaly is considered an EMH exception because there are historical data to substantiate a claim that says anomalies have produced excess risk-adjusted abnormal returns in the past. Several anomalies regarding fundamental analysis have been uncovered Whether these anomalies represent market inefficiency or poorly understood risk premiums is still a matter of debate. There are rational explanations for each, but not everyone agrees on the explanation. One dominant explanation on the irrational side is that many of these firms are also neglected firms, due to low trading volume, thus they are not part of an efficient market or offer more risk as a result of their reduced liquidity a. P/E effect. Recall that this describes the ability of a firm's P/E ratio to forecast future returns (low P/E leads to high returns and vice versa). In other words, firms with low prices today relative to earning shave high expected returns and vice versa. A rational explanation of this effect would be that it is driven by risk. Firms with low prices relative to earnings tend to be those who are either under distress or do not have many good growth prospects. b. Book-to-market (B/M) effect. This is similar to P/E, except the ratio is flipped (the market equity value is now in the denominator). Here, a high B/M ratio forecasts high returns and vice versa .c. Momentum effect. This is the effect whereby firms with high recent returns tend to have high future returns for up to about one year relative to firms with low recent returns. One rational explanation that has been proposed for the high average returns to trading on this effect is that it entails taking on risk .Specifically, it exposes investors to infrequent but large drawdowns such as during the financial crisis. d. Small-firm effect. This describes the fact that, on average, small firms have higher returns than large firms. One rational explanation for this is that small firms face higher risks of bankruptcy during economic downturns than large firms due to borrowing constraints (i.e., it is harder for these firms to borrow money than for large firms to borrow money, particularly during economic declines), and thus they are riskier

bubbles

Bubbles can be seen as evidence of market inefficiencies, as they involve prices that are disconnected from fundamental valuations and can lead to significant misallocations of resources. Most bubbles become obvious ex post, after the bubble has burst and prices have collapsed. This can be attributed to several factors, including the difficulty of identifying a bubble in real-time, the momentum and herd behavior that can sustain a bubble even in the face of fundamental valuations, and the psychological biases that can lead investors to overvalue certain assets. According to the EMH, stock prices should reflect all available information, including fundamental valuations, and any new information should be quickly incorporated into the market price, making it impossible for investors to consistently outperform the market.

Biases in Decision Making

Framing refers to the idea that the way choices are presented to individuals can affect their decisions. For example, people tend to be more risk-seeking when presented with options that are framed in terms of gains rather than losses. Mental accounting is another bias that affects how individuals make decisions. It refers to the tendency to treat different accounts or investments differently, based on how they are categorized in one's mind. For example, an investor may be more willing to use dividend income for current expenses than capital gains, even if the two sources of income are equivalent in terms of their value. Regret avoidance is the tendency to avoid taking actions that might lead to feelings of regret. For example, an investor may be more likely to invest in blue-chip stocks than in start-ups because they feel that they would regret losing money on a more speculative investment. The disposition effect refers to the tendency of investors to sell winning investments too early and hold on to losing investments for too long. This can lead to suboptimal investment decisions and lower returns. Finally, investor sentiment or affect can affect investment decisions. Feeling good or bad can affect how investors perceive different investments, leading to home bias (investing more in domestic companies) or higher prices and lower average returns for companies that are "admired" or popular.

Keynesian beauty contest

He argued that in stock markets, people often try to predict what other investors will do, rather than basing their decisions on their own independent analysis. This can lead to price fluctuations that are not necessarily based on the actual value of the stocks

Should returns be predictable if markets are efficient?

If markets are truly efficient, then returns should be unpredictable. The efficient market hypothesis (EMH) suggests that all available information is already reflected in asset prices, and therefore it is impossible to consistently achieve returns greater than the market average without taking on additional risk. If returns were predictable, investors would be able to take advantage of this information and earn above-average returns, causing market prices to adjust accordingly. This adjustment process would ultimately result in returns becoming unpredictable again.

Tests of Weak Form EMH Cont

Long Horizon Empirical evidence suggests that there is negative return autocorrelation from the momentum strategy between initial (positive) returns on the strategy and later (medium- to long-term) returns. This is commonly referred to as "reversal", where past winners tend to underperform in the long run while past losers tend to outperform. Possible explanations for the momentum strategy return patterns include the "fads hypothesis", which suggests that investors may irrationally chase performance of past winners leading to overpricing, and the risk premium hypothesis, which suggests that the momentum effect may be a compensation for higher risk taken by investing in past winners. There is evidence to suggest that some variables can predict broad stock index returns over the business cycle. These variables include the dividend-to-price ratio, earnings-to-price ratio, term spread, default spread, and the VIX (Volatility Implied Index). the presence of both short-term momentum and long-term reversal effects suggests that there may be some predictability in stock returns, which is not fully consistent with the weak form of the EMH.

Example 1: Incorrect expectations

Market participants get discount rates correct, but...- Do not have rational expectations about future prices and/or dividends if we incorrectly expect a higher dividend (13) instead of (11) using the same discount rate: today's prices will be higher we then get a negative return

Tests of Weak Form EMH

One way to test the weak form of the efficient market hypothesis (EMH) is to analyze the autocorrelation of stock returns over short horizons. Autocorrelation measures the degree to which a series of returns are correlated with their own past values. Short Horizon Empirical evidence suggests that broad stock indexes, such as the S&P 500, demonstrate weak autocorrelation among returns. This means that past returns are not useful in predicting future returns in the short term, supporting the weak form of the EMH. However, there is evidence to suggest that short-term momentum strategies, which involve going long on past winners and shorting past losers, can generate positive returns. This suggests that there may be some short-term predictability in stock returns, which is not consistent with the weak form of the EMH.

Post-Earnings Announcement

Post-Earnings Announcement Drift (PEAD) is another phenomenon that is inconsistent with the semi-strong form of the efficient market hypothesis. PEAD refers to the tendency for stock prices to drift in the direction of the earnings surprise (positive or negative) for several weeks or months following the release of quarterly earnings reports. As the graph shows, stocks with positive earnings surprises experience a positive abnormal return (above what would be expected based on historical returns) for several weeks following the announcement. Conversely, stocks with negative earnings surprises experience a negative abnormal return for several weeks following the announcement.

Errors in Information Processing

Representativeness bias: Investors may mistake a small sample or a limited set of information as representative of the entire population. For example, assuming that a company's recent strong earnings growth will continue indefinitely without considering the broader economic and industry factors that could impact its future performance.

Tests of Strong Form EMH

Since insider trading is illegal, it is difficult to directly test the strong form EMH. However, there are some indirect ways to assess the validity of the strong form EMH.

EMH Implications

Technical analysis is a method of evaluating securities by analyzing statistical trends and historical price movements If the weak form of the EMH holds, past returns should not predict future returns, and technical analysis should not be profitable. This suggests that there is no systematic relationship between historical price movements and future price movements, and that any patterns observed in the data are likely due to chance If the semi-strong form of the EMH holds, public information, such as earnings reports or macroeconomic data, cannot be used to predict future returns. Most fundamental analysis, which involves analyzing a company's financial statements and other relevant data, should not be profitable if this is the case. Finally, if the strong form of the EMH holds, private information, such as insider trading or corporate espionage, cannot be used to predict future returns. Trading strategies based on private information should not be profitable if this is the case.

Problems with Testing EMH

Testing the Efficient Market Hypothesis (EMH) can be difficult for a few reasons. First, we may observe some events or outcomes that appear to violate EMH, but these may simply be due to chance rather than a systematic inefficiency in the market. For example, if we flipped a coin 10 times and got heads every time, that doesn't necessarily mean the coin is biased - it could just be a lucky streak. Second, it can be hard to distinguish between a market inefficiency and a flaw in our asset pricing models. For example, if we observe a pattern in stock returns that can't be explained by the Capital Asset Pricing Model (CAPM), that doesn't necessarily mean the market is inefficient - it could just mean that the CAPM is incomplete or incorrect.

Other Evidence on EMH: Anomalies

The Capital Asset Pricing Model (CAPM) is consistent with the Efficient Market Hypothesis (EMH) because it assumes that investors hold diversified portfolios and that all investors have access to the same information about assets. The existence of anomalies poses a challenge to the efficient market hypothesis (EMH), as they suggest that some stocks may be mispriced, and therefore not fully reflecting all available information. The existence of these anomalies suggests that there may be opportunities for investors to earn excess returns by exploiting these patterns. However, the EMH argues that such patterns should not persist over time, as they should be arbitraged away by rational investors seeking to earn profits. The debate over the existence and persistence of anomalies remains an active area of research in finance. . If anomalies or inefficiencies are genuine, they should eventually disappear as they become widely known and exploited, leading to changes in prices that eliminate the opportunities for profit. However, if the anomalies are the result of missing risk factors or other persistent factors, they may persist over time.

22

The market may have anticipated even greater earnings. Compared to prior expectations, the announcement was a disappointment. Alternatively, the company could have given guidance for future earnings that was worse than the market expected. There are many ways to explain this effect as the result of rational behavior. This is an example of why it is so difficult to test the EMH

Behavioral Finance "Ingredients"

To summarize, for behavioral biases to have a significant impact on markets, two things must occur. First, irrational behavior must be systematic and have the potential to push prices away from their fundamental values. Second, arbitrage must be limited and unable to completely eliminate the mispricing. Several factors can limit arbitrage, including fundamental risk, implementation costs, and model risk. When arbitrage forces are strong, prices will be more efficient, and when they are weak, prices will be less efficient. Fundamental risk: If the mispricing is due to uncertainty about the underlying fundamentals of the asset, it may be difficult to know what the "correct" price should be. Implementation costs: It may be expensive or difficult to execute an arbitrage strategy, due to factors such as bid-ask spreads or borrowing costs for shorting. Model risk: The models used to identify mispricing may be imperfect or incomplete, which could lead to incorrect arbitrage opportunities being identified.

Do Individual Biases Always Translate toMispricing?

Yes, individual biases don't always translate to mispricing. This is because sometimes, the collective wisdom of a group of individuals can outweigh individual biases and lead to more accurate predictions.

Merger Announcements

a study of merger announcements found that there was significant insider trading activity prior to the announcement of the merger, suggesting that insiders had access to private information that was not yet reflected in the stock price. This suggests a violation of the semi-strong form of the EMH, as public investors were not able to fully incorporate this private information into the stock price.

ch 9 1

a-iv, b-iii, c-v, d-i, e-ii

17

a. Consistent. Half of all managers should outperform the market based on pure luck in any year. b. Violation of the weak form (from the perspective of the investor). This would be the basis for an "easymoney" rule: Simply invest with last year's best managers (i.e., based on past price information for thegiven fund, hence, a violation of the weak form). c. Consistent. Predictable volatility does not convey a means to earn abnormal returns. d. Violation of the semi-strong form. The abnormal performance ought to occur in January, when the increased earnings are announced (i.e., this is public information). e. Violation of the weak form. Reversals offer a means to earn easy money: Simply buy last week's losers(i.e., this strategy uses past price information to predict future returns)

6

c

Ch 8 12

c) This is a scenario where we can use past price patterns to earn abnormal returns, which is a scenario precluded if markets are weak-form efficient.

Some standard issues with testing EMH

we don't know much about future prices