Efficient Market Hypothesis

1
Efficient Market Hypothesis

• An efficient market is one where the market price
  is an unbiased estimate of the true value of the
  investment
• Market value does not equal true value
• Equal chance of under or over-valuation
• If true, no investor can consistently find under
  valued stocks

2
Types of Market Efficiency

• Weak form of efficiency
• Semi-strong form of efficiency
• Strong form of efficiency -

3
Implications of Market Efficiency

• Can you beat the market?
• What are the benefits of equity research?
• What is the best strategy?
• What is the relationship between risk and return?

4
Types of Investment Analysis

• Technical Analysis
• Fundamental Analysis
• Mixed Approach

5
Is the Market Rational? Fortune 12/9/02

• In one article we have many of the most famous
  names in Capital Markets theory
• Eugene Fama, U of Chicago
• Merton Miller, U of Chicago
• Kenneth French, Dartmouth
• Richard Thaler, U of Chicago
• William Sharpe U. of Stanford, then Wall Street
• Sharpe ratio and Beta
• Money Manager (to EMH professor) If you are so
  smart, why arent you rich? The professor
  replied, If youre so rich, why arent you
  smart?

6
Is the Market Rational?

• The Rational Strategy (arrives in the late
  60s)
• Buy and hold
• Diversification
• Index fund investments (first retail fund 1976)
• Control costs
• Vs
• Behavioral Finance
• Investors are irrational
• Prices are in part predictable based on past
  price movements
• Careful analysis can pay off!
• BUT Although you can beat the market, you likely
  wont so follow a rational strategy!

7
Is the Market Rational?

• Fama claims market anomalies are bad statistical
  work
• Efficient Market theorists say the price is
  right!
• Quote One of the most compelling of those
  models, and the one that seemed most closely to
  fit real-world data was the Efficient Market
  Hypothesis. It had its roots in empirical
  research that appeared to show stocks moving in a
  random walk-albeit with an upward trajectory for
  rising corporate earnings. The theoretical
  explanationwas that stock prices fluctuate
  randomly because all knowable information about
  the value of a stock is already discounted in the
  price and prices change only in reaction to news
  which is by definition unpredictable.

8
Is the Market Rational?

• Not everyone is rational, but so many are
  irrational in different ways they cancel each
  other out
• Behavioralists say that people making investment
  decisions make systematic and predictable errors
• January effect
• Value stocks with low price to book ratios
  outperform the market
• BUT, even behavioralists say
• Trade too much
• Dont diversify enough
• Count too much on recent past to make future
  decisions

9
Is the Market Rational?

• The Behavioralists view the market bubble of the
  90s as proof that investors are not rational
• Sharpe, a Rationalist supporter, could not
  explain the market crash of 1987. He described it
  as weird. His mother later told him, Fifteen
  years of education, three advanced degrees and
  all you can say is Its weird?
• CONCLUSIONS?
• Even behavioralists assume the markets are
  efficient when calculating cost of capital
• Even EMH supporters admit they need people to
  try to beat the markets to keep them efficient
• So, buy and hold, diversify and control your
  costs!

10
Anomalies in Technical and Fundamental Investing

• Technical
• Short-term positive correlations
• Long-term negative correlations
• Small Firms in January effect
• Fundamental
• Investing for value v. growth
• Vishny and Lalinshock
• Fama and French