MARKET EFFICIENCY adjustment for risk We can make money we can find a riskless arbitrage we can make money we can achieve an expected return which is large relative to the risk abnormal return Abnormal return E Rn Rf n E Rm Rf Definitions BEST A market is efficient if we cannot achieve significant abnormal returns A market is efficient if price changes are not predictable A market is efficient if security prices reflect all available information about value Efficient Market Hypothesis financial markets are informationally efficient Half of all managers should outperform the market based on luck in any year To study whether markets are efficient we need to specify the information we can use when seeking to achieve abnormal returns EMH says that investors expect to earn the same return regardless of the holding period because the risk in both securities is identical Reasons for Market Efficiency sophisticated investors access to publicly available information can eliminate any abnormal returns competition is source of efficiency there is no good theoretical reason to expect markets to be strong form efficient because they shouldn t have access to private information Weak Form cannot achieve abnormal returns by using information contained in market trading data includes prices trading volume etc Example Weak form efficiency implies that the following statement is incorrect Years when market goes up are expected to be followed by years when it goes down Example 2 If market is weak form efficient then technical analysis the search for predictable patterns in prices is futile Test for Market Efficiency Serial Correlation Returns Diagrams plot returns on two successive days and see whether there are any strong patterns Compass Rose patterns support weak form S P 500 vs Coin tossing technical trading rules are not consistently profitable Semi Strong Form cannot achieve abnormal returns by using publicly available information past prices trading volume company announcements macroeconomic announcements quality of management balance sheet composition earnings forecasts patent held etc Example Semi strong form efficiency implies that the following statement is incorrect after a dividend decreases the price decreases but the decrease takes place gradually over several days Example 2 Fundamental analysis research on determinants of stock value such as earnings and dividend prospects future interest rates etc is futile as long as it is based on publicly available information Test for Market Efficiency Takeover Announcements price responds quickly Dividend Announcements price responds quickly Assessment FAVORABLE after announcement CAR stays approx constant cannot achieve returns using publicly available information like P E UNFAVORABLE before takeover announcement CAR increases suggests information leakage and company insiders achieve abnormal returns Earnings Announcements Assessment NOT FULLY FAVORABLE on announcement date CAR is positive negative for stocks with positive negative earnings announcements consistent AND after announcement date CAR increases decreases for stocks with positive negative earnings announcements inconsistent Mutual Funds Performance test if mutual funds can consistently outperform their benchmarks NO because money managers cannot consistently outperform Assessment evidence of risk adjusted performance of money managers is MOSTLY SUPPORTIVE average funds do not achieve abnormal returns some mutual funds under perform consistently very few mutual funds over perform consistently Strong Form cannot achieve abnormal returns by using publicly available and private information prices reflect all information that is known by anyone including inside information Test for Market Efficiency Insiders Trading Assessment MIXED EVIDENCE on average trading of insiders seems to be profitable Tests are generally favorable to weak and semi strong forms it is difficult to achieve abnormal returns using publicly available information BUT tests are unfavorable to the strong form efficiency because it seems possible to achieve abnormal returns using private information VALUATION OF STOCKS Invest in stocks trading below their tangible book value Buffet s criteria large purchases demonstrated consistent earning power business earning good interest on equity while employing low debt good management in place simple businesses an offering price Look for securities with prices that are unjustifiably low based on their intrinsic work or fair value buy if price fair value Present value of all expected dividends cash flows should give us fair value DCF Model Constant growth P0 D1 r g P0 current price D0 current dividend g dividend growth rate r expected return Formula implies that price decreases if r discount rate increase bc risk increases OR if growth rate decreases Stocks vs Bonds Stock has infinite horizon whereas bond has fixed maturity stock has risky cash flows dividends whereas bonds have risk free cash flows coupons and face value stock s cash flows have to be discounted at risk adjusted discount rate whereas bond s cash flows are discounted at risk free rate BEHAVIOR FINANCE AND LIMITS TO ARBITRAGE Traditional Finance Paradigm investors are rational after receiving new info correctly updated their beliefs make investment and consumption choices to maximize subjective expected utility markets are efficient asset prices reflect the arbitrage free price of the asset as any deviation from this price will be arbitraged away Behavior Finance investors are irrational fail to update their beliefs correctly Cognitive Biases cognitive biases make choices that are incompatible with subjective expected utility preference based biases markets might be inefficient securities might be mispriced Heuristic Biases event may seem more likely depending on the way it is described Representativeness Heuristics people fail to use properly base rate information Jack hospital Linda conjunction fallacy Examples in finance technical analysis recommends searching for trends in the security prices and investing in the stocks with upward price dynamics investors appear to believe that past returns are indicative of future returns causes investors to buy stocks that represent desirable qualities Mix up good bad THINK good companies generate strong earnings have high sales growth and quality management growth glamour stocks bad companies are firms with the lowest sales growth value stocks BUT good are stocks that