Chapter 3 Market Efficiency
Chapter 3 Market Efficiency
Chapter 3 Market Efficiency
MARKET EFFICIENCY
Presenter
Venue
Date
DEFINITION OF AN EFFICIENT MARKET
Past information
Public information
Private
information
FACTORS AFFECTING MARKET
EFFICIENCY
Transaction costs
Time frame of and information-
price adjustments acquisition costs
Market
efficiency
Market value
Other factors versus intrinsic
value
ACTIVE VERSUS PASSIVE INVESTMENT
STRATEGIES
Market
efficiency
Active
investment
strategies
FACTORS AFFECTING A MARKET’S
EFFICIENCY
A market should be viewed as falling on a
continuum between two extremes:
Continuum
Completely Completely
Inefficient Efficient
Large Cap
Stocks
FORMS OF MARKET EFFICIENCY (FAMA 1970)
Prices reflect
public
information
Fundamental
analysis
THE EVENT STUDY PROCESS
STRONG FORM OF MARKET EFFICIENCY
Nonpublic Abnormal
information profits
QUESTIONS
1) Is the expected return for stocks equal to zero in
an efficient market?
2) Which hypothesis is being tested if a researcher
examines stock price performance following
earnings announcements?
3) Which hypothesis is being tested if a researcher
examines stock price performance based on a 50-
day and 200-day moving average of prices?
4) Why might a stock’s price not reflect everything
management knows about their company?
WHAT GOOD IS FUNDAMENTAL
ANALYSIS?
Value-relevant
information
Fundamental
analysis Possible
abnormal
returns
WHAT GOOD IS TECHNICAL ANALYSIS?
Usefulness of
past data Prevalence of
technical
analysis
WHAT GOOD ARE PORTFOLIO MANAGERS?
Manage
“Beat the
portfolio
market”
objectives
MARKET PRICING ANOMALIES
Market
efficiency
Existence of
market
pricing
anomalies
EXHIBIT 3-3 SAMPLING OF OBSERVED
PRICING ANOMALIES
Tax loss
selling
Other
Window
explanation
dressing
s
January
effect
EXHIBIT 3-4 OTHER CALENDAR-BASED
ANOMALIES
Anomaly Observation
Turn-of-the-month Returns tend to be higher on the last trading day of the month and
effect the first three trading days of the next month.
Day-of-the-week effect The average Monday return is negative and lower than the average
returns for the other four days, which are all positive.
Weekend effect Returns on weekends tend to be lower than returns on weekdays.
Holiday effect Returns on stocks in the day prior to market holidays tend to be
higher than other days.
OVERREACTION AND MOMENTUM
ANOMALIES
Value
outperforms
growth
Small cap
outperforms
large cap
CLOSED-END INVESTMENT FUNDS
Value of
NAV Discount closed-
end fund
EARNINGS SURPRISE
Positive
Beginning
earnings Price rises
price
surprise
Negative
Ending price Price falls earnings
surprise
INITIAL PUBLIC OFFERINGS (IPOS)
Offering
price
Closing
price
Abnormal
profits
“FRONTIERS OF FINANCE SURVEY”
THE ECONOMIST (9 OCTOBER 1993)
Like gains
Dislike losses
OVERCONFIDENCE
Investor
overconfidence
Mispriced
New information
securities
OTHER BEHAVIORAL BIASES
Representativeness
Gambler’s fallacy
Mental accounting
Conservatism
Disposition effect
Narrow framing
INFORMATION CASCADES
Uninformed
Release of Informed
1 2 3
traders imitate
information traders trade
informed traders
IF INVESTORS SUFFER FROM COGNITIVE BIASES,
MUST MARKETS BE INEFFICIENT?