FIN 437 Vicentiu Covrig The Efficient Capital Markets

FIN 437 Vicentiu Covrig The Efficient Capital Markets and Behavioral Finance (chapter 9 in Strong, Chapters in Nofsinger) 1

FIN 437 Vicentiu Covrig The Efficient Market Hypothesis Operational efficiency is a measure of how well things function in terms of speed of execution and accuracy. u Informational efficiency is a measure of how quickly and accurately the market reacts to new information. u The efficient market hypothesis (EMH) deals with informational efficiency. u Why does it matter? 2

FIN 437 Vicentiu Covrig Alternative Efficient Market Hypotheses The various forms of the efficient market hypothesis differ in terms of the information that security prices should reflect. n Weak-form EMH n Semistrong-form EMH n Strong-form EMH 3

FIN 437 Vicentiu Covrig Weak-Form EMH n n Current prices fully reflect all security-market information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information This implies that past rates of return and other market data should have no relationship with future rates of return An autocorrelation test investigates whether security returns are related through time A runs test, for example, measures the likelihood that a series of two variables is a random occurrence. Implication: n Examining recent trends in price and other market data (called Technical analysis) in order to predict future price changes would be a waste of time if the market is weak-form efficient 4

FIN 437 Vicentiu Covrig Tests and Results: Weak-Form EMH Problems with tests n Cannot be definitive since trading rules can be complex and there are too many to test them all n Testing constraints - Use only publicly available data - Should include all transactions costs - Should adjust the results for risk (an apparently successful strategy may just be a very risky strategy) If someone writes a book on how to “beat the market, ” you can bet that book sales are more lucrative than the trading strategy! Even if it once worked, if it’s widely known, it won’t work any more! 5

FIN 437 Vicentiu Covrig Semistrong-Form EMH n n n Current security prices reflect all public information, including market and nonmarket information This implies that decisions made on new information after it is public should not lead to above-average risk-adjusted profits from those transactions Event studies involving phenomena occurring at known points in time, such as a stock split or the announcement of corporate earnings, are frequently used in tests of the semistrong form of market efficiency Implication: n If the market is efficient in this sense, information in The Wall Street Journal, other periodicals, and even company annual reports is already fully reflected in prices, and therefore not useful for predicting future price changes. 6

FIN 437 Vicentiu Covrig Strong-Form EMH n Stock prices fully reflect all information from public and private sources Implication: Not even “insiders” would be able to “beat the market” on a consistent basis Evidence does not support strong form EMH. Insiders can make a profit on their knowledge, and people go to jail, get fined, or get suspended from trading for doing so. 7

FIN 437 Vicentiu Covrig Anomalies The low PE effect : Some evidence indicates that low PE outperform higher PE stocks of similar risk. stocks Low-priced stocks : Many people believe that the price of every stock has an optimum trading range. The small firm effect : Small firms seem to provide superior risk-adjusted returns. The neglected firm effect : Neglected firms seem to offer superior returns with surprising regularity 8

FIN 437 Vicentiu Covrig Anomalies Market Overreaction and Momentum : It is observed that the market tends to overreact to extreme news. So, systematic price reversals can sometimes be predicted. Security Analysts n This looks at whether, after a stock selection by an analyst is made known, a significant abnormal return is available to those who follow their recommendation n There is some evidence of superior analysts, and as a group the stocks with better analysts ratings have better returns n The Value Line Enigma - Firms ranked 1 substantially outperform the market; firms ranked 5 substantially underperform the market 9

FIN 437 Vicentiu Covrig Other Tests and Results Professional Money Managers n If any investor can achieve above-average returns, it should be this group n If any non-insider can obtain inside information, it would be this group due to the extensive management interviews that they conduct n Risk-adjusted returns of mutual funds generally show that most funds did not match aggregate market performance 10

FIN 437 The Rationale and Use of Index Funds (passive investing) Vicentiu Covrig n n Efficient capital markets and a lack of superior analysts imply that many portfolios should be managed passively (so their performance matches the aggregate market, minimizes the costs of research and trading) Institutions created market (index) funds which duplicate the composition and performance of a selected index series 11

FIN 437 Vicentiu Covrig Behavioral Finance (see chapters 3, 5 and 8 from Nofsinger) 12

FIN 437 Vicentiu Covrig Behavioral Finance vs Standard Finance Behavioral finance considers how various psychological traits affect investors Behavioral finance recognizes that the standard finance model of rational behavior can be true within specific boundaries but argues that this model is incomplete since it does not consider the individual behavior. Currently there is no unified theory of behavioral finance, thus the emphasis has been on identifying investment anomalies that can be explained by various psychological traits. 13

FIN 437 Vicentiu Covrig Loss Aversion and Mental Accounting First decision: Choose between Choice 1: sure gain of $ 85, 000 Choice 2: 85% chance of receiving $100, 000 and 15% chance of receiving nothing Second decision: Choose between Choice 1: sure loss of $ 85, 000 Choice 2: 85% chance of losing $100, 000 and 15% chance of losing nothing 14

FIN 437 Vicentiu Covrig Mental Accounting Individuals tend to keep a mental account for each investment option, instead of looking at the investment decisions as a “package” Many investors are highly risk averse with money in some accounts and risk lovers with money in other accounts 15

FIN 437 Vicentiu Covrig Mental Accounting Imagine that you are planning to buy a TV in six months. The TV will cost you $1, 500. You have two options for financing the purchase: A. Five monthly payments of $300 each during the five months before you get the TV B. Five monthly payments of $300 each during the five months after you get the TV. Imagine that you are planning a vacation to Thailand in six months. The vacation will cost you $1, 500. You have two options for financing the vacation: A. Five monthly payments of $300 each during the five months before the vacation. B. Five monthly payments of $300 each during the five months after the vacation. 16

FIN 437 Vicentiu Covrig Mental Accounting: sunk costs You have a ticket to a Dodgers game, ticket worth $60. On the day of the game there is a big rain. Although you can still go to the game and the game is playing, the rain will reduce the pleasure of watching the game. Are you more likely to go to the game if you purchased the ticket or if the ticket was given to you for free? 17

FIN 437 Vicentiu Covrig Seeking pride and avoiding regret Rational individuals feel no greater disappointment when they miss their plane by a minute as when they miss it by an hour. What about most of us? Most of the investors sell winners too early, riding losers too long (called the disposition effect) Individuals who make decisions that turn out badly have more regret when that decisions were more unconventional 18

FIN 437 Vicentiu Covrig Overconfidence: people tend to overestimate their ability More than 70% of drivers ranked themselves as above the average Overconfidence lead to poor investment decisions which often are tied to excessive trading and risk taking Is increased trading necessarily bad? Overconfidence might lead managers to accept a suboptimal project and to continue a failed project for too long 19

FIN 437 Vicentiu Covrig Overconfidence and risk: Overconfidence and experience: - new investors expected a higher return - new investors were more confident about their ability to beat the market 20

FIN 437 Vicentiu Covrig Learning outcomes: • Explain what do we understand by market efficiency, and discuss the three definitions of market efficiency • Know how to discuss the examples of market anomalies presented in the notes • Explain the following behavioral “flaws” as applied to finance: - mental accounting - overconfidence - regret 21