The Efficient Capital Markets and Behavioral Finance

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• The Efficient Capital Markets and Behavioral
  Finance
• (chapter 9 in Strong, Chapters in Nofsinger)

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The Efficient Market Hypothesis

• Operational efficiency is a measure of how well
  things function in terms of speed of execution
  and accuracy.
• Informational efficiency is a measure of how
  quickly and accurately the market reacts to new
  information.
• The efficient market hypothesis (EMH) deals with
  informational efficiency.

Why does it matter?
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Alternative Efficient Market Hypotheses

• The various forms of the efficient market
  hypothesis differ in terms of the information
  that security prices should reflect.
• Weak-form EMH
• Semistrong-form EMH
• Strong-form EMH

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Weak-Form EMH

• 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

• 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

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Tests and Results Weak-Form EMH

• Problems with tests
• Cannot be definitive since trading rules can be
  complex and there are too many to test them all
• 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 its widely known, it wont work
any more!
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Semistrong-Form EMH

• Current security prices reflect all public
  information, including market and non-market
  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

• 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.

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Strong-Form EMH

• 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.
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Anomalies

• The low PE effect Some evidence indicates that
  low PE stocks outperform higher PE stocks of
  similar risk.
• 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

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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
• 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
• There is some evidence of superior analysts, and
  as a group the stocks with better analysts
  ratings have better returns
• The Value Line Enigma
• Firms ranked 1 substantially outperform the
  market firms ranked 5 substantially underperform
  the market

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Other Tests and Results

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

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The Rationale and Use of Index Funds(passive
investing)

• 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

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Behavioral Finance (see chapters 3, 5 and 8
from Nofsinger)
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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.
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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
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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
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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.
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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?
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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
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Overconfidence
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
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Overconfidence
Overconfidence and risk Overconfidence and
experience - new investors expected a higher
return - new investors were more confident
about their ability to beat the market
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• 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