Stock Market Efficiency: Alternative Views

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Stock Market Efficiency Alternative Views

• Corporate Finance 27

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Stock market efficiency alternative views

• Views of professional investors
• Whether stock markets appear to absorb all
  relevant (public or private) information
  (strong-form efficiency)
• The behavioural-based arguments leading to a
  belief in inefficiencies
• The implications of the evidence for efficiency
  for investors and corporate management

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Comment on the semi-strong efficiency evidence

• Despite the evidence of some work showing
  departures from semi-strong efficiency, for
  most investors most of the time the market may
  be regarded as efficient
• The evidence for semi-strong efficiency is
  significant but not so overwhelming that there
  is no hope of outperformance for the able and
  dedicated
• Publication bias
• Hundreds of researchers examining the data
• A lot of evidence of inefficiency that remains
  hidden
• Paradox in order for the market to remain
  efficient there has to be a large body of
  investors who believe it to be inefficient

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The views of some successful investors

• Peter Lynch
• Quantitative analysis taught me that the things I
  saw happening at Fidelity couldnt really be
  happening. I also found it difficult to integrate
  the efficient market hypothesis It also was
  obvious that the Wharton professors who believed
  in quantum analysis and random walk werent doing
  nearly as well as my new colleagues at Fidelity
• John Neff
• Always on the lookout for out-of-favour,
  overlooked or misunderstood stocks
• He believes that the market tends to allow itself
  to be swept along with fads, fashions and
  flavours of the month. This leads to
  overvaluation of those stocks regarded as
  shooting stars, and to the undervaluation of
  those which prevailing wisdom deems unexciting,
  but which are fundamentally good stocks

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The views of some successful investors

• Benjamin Graham
• The prices of common stock are not carefully
  thought out computations,but the resultants of a
  welter of human reactions. The stock market is a
  voting machine rather than a weighing machine
• The processes by which the securities market
  arrives at its appraisals are frequently
  illogical and erroneous. These processes . . .
  are not automatic or mechanical, but
  psychological for they go on in the minds of
  people who buy and sell. The mistakes of the
  market are thus the mistakes of groups of masses
  of individuals. Most of them can be traced to one
  or more of three basic causes exaggeration,
  oversimplification, or neglect

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The views of some successful investors

• Warren Buffett and Charles Munger
• Im convinced that there is much inefficiency in
  the market . . . When the price of a stock can be
  influenced by a herd on Wall Street with prices
  set at the margin by the most emotional person,
  or the greediest person, or the most depressed
  person, it is hard to argue that the market
  always prices rationally. In fact, market prices
  are frequently nonsensical . . . There seems to
  be some perverse human characteristic that likes
  to make easy things difficult. The academic
  world, if anything, has actually backed away from
  the teaching of value investing over the last 30
  years. Its likely to continue that way. Ships
  will sail around the world but the Flat Earth
  Society will flourish

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Strong-form tests

• It is possible to trade shares on the basis of
  information not in the public domain and make
  abnormal profits
• Trading on inside knowledge is thought to be a
  bad thing
• Insider dealing is considered to be, besides
  dealing for oneself either counselling or
  procuring another individual to deal in the
  securities or communicating knowledge to any
  other person, while being aware that he or she
  (or someone else) will deal in those securities
• The term insider covers anyone with sensitive
  information, not just a company director or
  employee
• Raise the level of information disclosure
• Prohibit certain individuals from dealing in the
  companys shares for crucial time periods

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Behavioural finance

• Behavioural finance proponents argue that
  investors frequently make systematic errors
  and these errors can push the prices of shares
  away from fundamental value for
  considerable periods
• Behavioural finance models offer plausible
  reasoning for the phenomena we observe in the
  pattern of share prices
• They offer persuasive explanations for the
  outperformance of low PER,high dividend yield
  and low book-to-market ratio shares as well
  as the poor performance of glamourshares
• They also shed light on both return reversal and
  momentum effects, stock market bubbles and
  irrational pessimism

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The three lines of defence for EMH
1 Investors are rational and hence value
securities rationally 2 Even if some investors
are not rational, their irrationally
inspired trades of securities are random and
therefore the effects of their irrational
actions cancel each other out without
moving prices away from their efficient level 3
If the majority of investors are irrational in
similar ways and therefore have a tendency
to push security values away from the
efficient level this will be countered by
rational arbitrageurs who eliminate the
influence of the irrational traders on
prices
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Arbitrage

• Arbitrage is the act of exploiting price
  differences on the same security or similar
  securities by simultaneously selling the
  overpriced security and buying the
  underpriced security
• Perfect arbitrage a profit without any risk at
  all (and even without money)
• To be effective the arbitrageur needs to be able
  to purchase or sell a close-substitute
  security
• For example you discover that Unilevers shares
  are undervalued
• The risk of other fundamental factors influencing
  the shares of Unilever and PG
• The risk that the irrational investors push
  irrationality to new heights
• Risk arbitrage and risk-free arbitrage

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Some cognitive errors made by investors

• The combination of limited arbitrage and investor
  sentiment pushing the market leads to
  inefficient pricing
• Both elements are necessary
• Overconfidence
• Representativenes
• Conservatism
• Narrow framing
• Ambiguity aversion

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Some cognitive errors made by investors
(continued)

• Positive feedback and extrapolative expectations
• Regret
• Confirmation bias
• Cognitive dissonance
• Availability bias
• Miscalculation of probabilities
• Anchoring

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Misconceptions about the efficient market
hypothesis
1 Any share portfolio will perform as well as or
better than a special trading rule
designed to outperform the market 2 There
should be fewer price fluctuations 3 Only a
minority of investors are actively trading, most
are passive, therefore efficiency cannot be
achieved
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Implications of the EMH for investors
1 For the vast majority of people public
information cannot be used to earn abnormal
returns 2 Investors need to press for a greater
volume of timely information 3 The perception
of a fair game market could be improved by
more constraints and deterrents placed on
insider dealers
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Implications of the EMH for companies
1 Focus on substance, not on short-term
appearance 2 The timing of security issues does
not have to be fine- tuned 3 Large
quantities of new shares can be sold without
moving the price 4 Signals from price
movements should be taken seriously
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Concluding comments

• Sophisticated stock markets are substantially
  efficient
• Question the assumption that all investors
  respond in a similar manner to the same risk
  and return factors and that these can be
  easily identified
• One way of outperforming the market might be to
  select shares the attributes of which you
  dislike less than the other investors
• Another way is through luck
• Possessing superior analytical skills
• Through the discovery of a trading rule which
  works
• To be quicker than anyone else
• To become an insider

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Lecture review

• Strong-form efficiency
• Insider dealing
• Behavioural finance studies
• Implications of the EMH for investors
• Implications of the EMH for companies