Efficient Market Hypothesis

market inefficiency

One of the ways to think about market inefficiency is that it implies there is easy money to be made. The following appear to suggest market inefficiency: (b) strong form (d) weak form (f) semi-strong form

c. "The trouble with the efficient-market theory is that it ignores investors' psychology."

As suggested before, there is plenty of room for "investor psychology" in an efficient market. Investor psychology is a slippery concept, more often than not used to explain price movements that the individual invoking it cannot personally explain. Even if it exists, is there any way to make money from it? If investor psychology drives up the price one day, will it do so the next day also? Or will the price drop to a 'true' level? Almost no one can tell you beforehand what 'investor psychology' will do. Theories based on it have no content. The trouble with investor psychology is that it can be used after the fact to explain any stock price movement.

Give two or three examples of research results or events that raise doubts about market efficiency. Briefly explain why.

Example 1: Evidence that two securities with identical cash flows (e.g., Royal Dutch Schell and Shell Transport & Trading) can sell at different prices. Example 2: Small-cap stocks and high book-to-market stocks appear to have given above-average returns for their level of risk. Example 3: IPOs provide relatively low returns after their first few days of trading. Example 4: Stocks of firms that announce unexpectedly good earnings perform well over the coming months. In each case, there appear to have been opportunities for earning superior profits

c. In efficient markets, the expected return on each stock is the same.

False

Geothermal Corporation has just received good news: its earnings increased by 20% from last year's value. Most investors are anticipating an increase of 25%. Will Geothermal's stock price increase or decrease when the announcement is made?

It will decrease because an efficient market responds to NEW information. Since it was expecting an increase of 25% but the increase was only 20%, then the new information is bad news.

"The random-walk theory implies that events are random, but many events are not random. If it rains today, there's a fair bet that it will rain again tomorrow."

Random-walk theory as applied to efficient markets means that fluctuations from the expected outcome are random. Suppose there is an 80 percent chance of rain tomorrow (because it rained today). Then the local umbrella store's stock price will respond today to the prospect of high sales tomorrow. The store's sales will not follow a random walk, but its stock price will, because each day the stock price reflects all that investors know about future weather and future sales.

On May 15, 1997, the government of Kuwait offered to sell 170 million BP shares, worth about $2 billion. Goldman Sachs was contacted after the stock market closed in London and given one hour to decide whether to bid on the stock. They decided to offer 710.5 pence ($11.59) per share, and Kuwait accepted. Then Goldman Sachs went looking for buyers. They lined up 500 institutional and individual investors worldwide, and resold all the shares at 716 pence ($11.70). The resale was complete before the London Stock Exchange opened the next morning. Goldman Sachs made $15 million overnight. What does this deal say about market efficiency? Discuss.

The market is most likely efficient. The government of Kuwait is not likely to have non-public information about the BP shares. Goldman Sachs is providing an intermediary service for which they should be remunerated. Stocks are bought by investors at (higher) ask prices and sold at (lower) bid prices. The spread between the two ($0.11) is revenue for the broker. In the U.S., at that time, a bid-ask spread of 1/9 ($0.25) was not uncommon. The 'profit' of $15 million reflects the size of the order more than any mispricing.

"If everyone believes you can make money by charting stock prices, then price changes won't be random."

To make the example clearer, assume that everyone believes in the same chart. What happens when the chart shows a downward movement? Are investors going to be willing to hold the stock when it has an expected loss? Of course not. They start selling, and the price will decline until the stock is expected to give a positive return. The trend will 'self-destruct.'

The semi-strong form of the efficient-market hypothesis states that prices reflect all publicly available information.

True. The EMH states again that security prices reflect all available information. And the definition of available information is what distinguishes the strong form from the semi-strong form from the weak form. And, just to be complete, the strong form defines available information as public and private information, the semi-strong form defines available information as publicly available information, and the weak form defines available information as past prices and, in some versions, past trading volume.

Psychologists have observed that people tend to put too much weight on recent events when forecasting

True. This is called the Recency Effect where people tend to overweight recent events. This effect can at least partly explain the financial crises because stock markets and economies around the world had experienced an unprecedented period of growth for the previous 25 years. And it is not hard to imagine that investors over-weighted this period and ignored most distant periods when economies faltered and stock markets tanked in constructing their forecasts.

"Despite all the limitations, the best guide to a company's value is its written-down book value. It is much more stable than market value, which depends on temporary fashions."

What good is a stable value when you can't buy or sell at that value because new conditions or information have developed which make the stable price obsolete? It is the market price, the price at which you can buy or sell today, which determines value.

Here again are the six lessons of market efficiency. For each lesson, give an example showing the lesson's relevance to financial managers. a. Markets have no memory. b. Trust market prices. c. Reach the entrails. d. There are no financial illusions e. The do-it yourself alternative. f. Seen one stock, seen them all.

a. An investor should not buy or sell shares based on apparent trends or cycles in returns. b. A CFO should not speculate on changes in interest rates or foreign exchange rates. There is no reason to think that the CFO has superior information. c. A financial manager evaluating the creditworthiness of a large customer could check the customer's stock price and the yield on its debt. A falling stock price or a high yield could indicate trouble ahead. d. Don't assume that accounting choices that increase or decrease earnings will have any effect on stock price. e. The company should not seek diversification just to reduce risk. Investors can diversify on their own. f. Stock issues do no depress price if investors believe the issuer has no private information.

a. "Efficient market, my eye! I know lots of investors who do crazy things."

a. As stated before, there is plenty of room for irrational investors (i.e., crazy or simply dumb investors) in an efficient market. We just need a core of smart investors or for the irrationalities to cancel each other out (recall the wisdom of the crowds) in order for the markets to be efficient. Interestingly, an efficient market helps protect irrational investors from themselves because security prices will rationally reflect intrinsic value.

a. Tests have shown that there is almost perfect negative correlation between successive price changes.

a. False. In contrast to the weak form of the EMH, there is evidence that stock price changes are not independent, but there is no evidence of an almost perfect negative correlation between successive price changes.

True or false? The efficient-market hypothesis assumes that a. There are no taxes. b. There is perfect foresight. c. Successive price changes are independent. d. Investors are irrational. e. There are no transaction costs. f. Forecasts are unbiases.

a. False. Taxes, of course, can affect the valuation of a security but the EMH does not make any assumption about taxes. Remember that an efficient market is one in which security prices reflect all available information. And the existence of taxes is one piece of information that is reflected in security prices when the market is efficient. b. False. The EMH does not assume that investors are God-like in their ability to perfectly forecast the future. It merely assumes that investors are unbiased in their forecasts. In other words, investors' forecasts should be correct on average. So, for example, they may be overly optimistic in their forecasts of some firms' dividends and overly pessimistic in their forecasts of other firms' dividends but these forecast errors cancel each other out so that across the entire sample of firms, the forecast error is insignificantly different from zero. c. True. Recall again that in an efficient market, security prices reflect all available information. This means that they should only change in response to new information. New information is, by definition, unpredictable (otherwise it wouldn't be new). Therefore, security price changes are unpredictable. So, security price changes are independent of one another. In other words, we cannot infer anything about the future change in a security price based on its past changes. d. False. The EMH essentially says that the market is rational. In other words, security prices are unbiased reflections of intrinsic value, where intrinsic value can be defined as the present value of the unbiased forecast of the cash flows that a security will generate. Now, the EMH does not assume that every investor in the market is rational. Indeed, there is plenty of room for irrational investors in an efficient market as long as there is a core of rational investors who are the ultimate price setters and/or the irrational investors cancel each other out as is illustrated in the concept of the wisdom of the crowds. But allowing for the existence of irrational investors is a far cry from the blanket assumption that "investors are irrational" and that is why the answer is "False." e. False. Transaction costs do make it more difficult for investors to exploit any difference between a security's price and its intrinsic value but the EMH does not assume that there are no transaction costs. f. True. As explained in the answer to question 1.b., the EMH does not assume that investors have perfect foresight but it does assume that they are unbiased in their forecasts.

"The strong-form of the efficient-market hypothesis is nonsense. Look at mutual fund X; it has had superior performance for each of the last 10 years." Does the speaker have a point? Suppose that there is a 50% probability that X will obtain superior performance in any year simply by chance. a. If X is the only fund, calculate the probability that it will have achieved superior performance for each of the past 10 years. b. Now recognize that there are over 10,000 mutual funds in the United States. What is the probability that by chance there is at least 1 out of 10,000 funds that obtained 10 successive years of superior performance?

a. The probability that mutual fund X achieved superior performance in any one year is 0.50. The probability that mutual fund X achieved superior performance in each of the past ten years is: 0.510 = 0.00097656 b. The probability that, out of 10,000 mutual funds, none of them obtained ten successive years of superior performance is: (1-.00097656)10,000 = 0.00005712 Therefore, the probability that at least one of the 10,000 mutual funds obtained ten successive years of superior performance is: 1 - 0.00005712 = 0.99994288

"The random-walk theory, with its implication that investing in stocks is like playing roulette, is a powerful indictment of our capital markets."

a. There is risk in almost everything you do in daily life. You could lose your job or your spouse, or suffer damage to your house from a storm. That doesn't necessarily mean you should quit your job, get a divorce, or sell your house. If we accept that our world is risky, then we must accept that asset values fluctuate as new information emerges. Moreover, if capital markets are functioning properly, then stock price changes will follow a random walk. The random walk of values is the result of rational investors coping with an uncertain world.

b. "Efficient market? Balderdash! I know at least a dozen people who have made a bundle in the stock market."

b. There are plenty of people who have made a bundle in the stock market despite their irrational investment styles. But there have been many more who have lost a bundle. In other words, an efficient market does not rule out chance. Indeed, the role of chance is why stock price changes are unpredictable because new information is unpredictable. And so, there is always a chance that fools will get lucky and rational people will get unlucky. To see this perhaps more clearly, there are announcements of lottery winners every day. We know from basic statistics that buying a lottery ticket is irrational in the sense that the ticket costs more than it is worth given the odds of winning and the size of the winnings. Of course, the lottery winners can smirk at this notion but I think that most people understand that just because some people win the lottery doesn't make buying a lottery ticket a rational thing to do (unless you just get some psychic pleasure from doing so). Similarly, just because some people earn abnormal returns on their investments doesn't mean that the market is irrational or inefficient.