Unlock document.
This document is partially blurred.
Unlock all pages and 1 million more documents.
Get Access
Chapter 08 - The Efficient Market Hypothesis
CHAPTER EIGHT
THE EFFICIENT MARKET HYPOTHESIS
CHAPTER OVERVIEW
This chapter examines the concept of market efficiency. We are asking whether securities are,
on average, fairly priced according to the benefits they give an investor. If they are then one
cannot expect to consistently earn more than one should for the risk level you are taking. In other
words you cannot consistently beat the market’s risk-adjusted return. There are two aspects of
efficiency, although the text does not explicitly separate the two. In an informationally-efficient
market, price changes are unpredictable. It is this aspect of efficiency with which the text is
concerned. However we may also ask a related question, “Are the markets efficient allocators of
LEARNING OBJECTIVES
After studying this chapter, the student should thoroughly understand the concept of
informational market efficiency and how to make rational investment decisions based upon the
existence of market efficiency. The student also should have a working knowledge of some tests
of market efficiency, the forms of market efficiency, and observed market anomalies. Market
efficiency is akin to the perfect competition model to which it is related. Like perfect
competition, it should be interpreted as an ideal that markets move toward but will probably
never completely and consistently achieve. Nevertheless the financial markets are highly
competitive and it is likely that markets will closely approach efficiency, the occasional bubbles
notwithstanding. Bubbles remind us that math and models of cash flows, etc., do not drive
Chapter 08 - The Efficient Market Hypothesis
CHAPTER OUTLINE
1. Random Walks and the Efficient Market Hypothesis
PPT 8-2 through PPT 8-6
Definitions of informational and allocational efficiency are provided. Implications of efficiency
are then discussed and the idea of random walk is introduced and illustrated. Note that we
actually expect there to be a positive trend in stock prices albeit with random movements around
those positive trends. The reason that we would expect to see price changes that are random is
related to efficiency. If information that has importance for stock values arrives or occurs in a
random fashion, price changes will occur randomly. If the market is efficient in its analysis, the
change in prices will reflect that information in a timely basis.
The forms of the efficient market are presented. In a weak-form efficient market, prices will
reflect all information that can be derived from trading data such as prices and volumes. In a
semi-strong form, market prices will reflect all publicly available information regarding the
firm’s prospects. In a strong-form market, prices would reflect all information relevant to the
firms' prospects, even inside information. It is important that students understand the following
Venn diagram.
Many students struggle with this concept so it is worth taking the time to point out the
relationships among the different forms of efficiency.
Chapter 08 - The Efficient Market Hypothesis
2. Implications of the EMH (for Security Analysis)
PPT 8-7 through PPT 8-10
Technical and fundamental analyses are defined in this section as well as the implications of the
different forms of market efficiency with respect to security analysis. If markets are weak-form
efficient, technical analysis, such as charting, should not result in superior profits. If markets are
semi-strong form efficient, fundamental analysis should not result in consistent superior profits.
Fundamental analysis involves using information on the economy as well as information such as
earning trends and profit trends to find undervalued securities. If markets are at least semi-strong
efficient, investors would tend to employ passive strategies such as buying indexed funds or
employing a diversified buy-and-hold strategy. Active management such as security analysis or
attempting to time the market would not result in consistently superior profits if markets are
efficient.
3. Are Markets Efficient?
PPT 8-11 through PPT 8-22
Over time stock prices tend to follow a submartingale. This has nothing to do with efficiency,
per se. It does however have serious implications for tests of efficiency. This implies that a
randomly chosen portfolio of stocks can be expected to have a positive return. In practice this
means that when trying to figure out if some portfolio manager is earning abnormal returns we
must compare their performance to the performance of a randomly chosen portfolio. That is,
they must outperform the random portfolio or, in practice, they must beat some benchmark rate
of return. The magnitude, selection bias and lucky-event issues are covered, as well as possible
model misspecification. Because a model of expected return is needed to assess whether an
investor or an investment rule earns excess return, tests of market efficiency are joint tests of the
model used to estimate expected returns and market efficiency. Therefore, even when an
anomaly is discovered, we have to be careful in interpreting the results. Some apparent
anomalies are discussed including the Fama-French results, the Keim and Stambaugh findings
and the Campbell and Shiller work. Note that each of these results may also be consistent with
changing risk premiums and may have nothing to say about market efficiency. Some anomalies
do not have staying power after being reported.
Chapter 08 - The Efficient Market Hypothesis
Periodically, stock prices appear to undergo a ‘speculative bubble.’ A speculative bubble is said
to occur if prices do not equal the intrinsic value of the security. Does this imply that markets
are not efficient? There is no definitive answer to this question. However we can make some
observations:
• It is very difficult to predict if you are in a bubble and when the bubble will burst. Stock
prices are estimates of future economic performance of the firm and these estimates can
change rapidly.
• Risk premiums can change rapidly and dramatically.
Nevertheless, with hindsight there appear to be times when stock prices decouple from intrinsic
or fundamental value, sometimes for years. What does this imply?
• Prices eventually conform once more to intrinsic value. Many who don’t believe in
efficient markets anyway have jumped on this result to pronounce the death of market
efficiency. However, the bubbles bring into question the allocational efficiency of the
markets more than the informational efficiency. Very few people will be able to
consistently predict the extent and duration of a bubble.
• Some claim the bubbles imply that investors are irrational. Perhaps, but think about what
determines the price of gold. Is it irrational to buy an asset for more than its fundamental
value if you believe that you can sell it for more than you paid for it? It is indeed risky to
engage in this type of transaction, but is it irrational?
Chapter 08 - The Efficient Market Hypothesis
Copyright © 2019McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
Some of the major types of tests that researchers have done on market efficiency are described. If
markets are inefficient, then professionals who spend considerable resources in investment
should secure superior performance. The tests are broken down in terms tests of the forms of
efficiency. Tests have uncovered some inefficiency in pricing but many possible interpretations
of results are possible. Tests of weak-form efficiency show small magnitudes of positive
correlation for very short term tests; hence prices do not strictly conform to a random walk.
Studies of returns for periods of 3 to 12 months offer evidence of positive momentum. Longer
horizon tests have uncovered some pronounced negative correlation. Tests do document
tendencies for long term reversals in results. This may be because of information flow in
competitive markets. People rush to buy recent winners and in so doing drive up the price
enough so that future returns are not abnormal. This does not imply inefficiency unless the same
investors can consistently do this. Attempting to interpret the results of efficiency tests has led to
various explanations ranging from model misspecification to data mining.
4. Mutual Fund and Analyst Performance
PPT 8-23 through PPT 8-30
Some recent studies on mutual funds have documented some persistence in positive and negative
performance. Some researchers question whether the performance is abnormal or whether the
studies have measurement errors or model biases. The overall test results are mixed at best but
the evidence shows that some superstars exist. Note that Warren Buffet’s portfolio, (Buffet is
one of the postulated superstars) took quite a beating in the financial crisis of 2008. Although
the evidence is not conclusive, it appears safe to state that the ability to consistently earn
abnormal returns, greater than one should for the risk level undertaken, is very rare.
Chapter 08 - The Efficient Market Hypothesis
Chapter 08 - The Efficient Market Hypothesis
