Reading 38: Market Efficiency

General Concepts

Informational Efficient

Security prices reflect all available information fully, quickly and rationally.

The more efficient the market, the quicker its reaction to new information.

Only unexpected information would elicit trader's response.

Fully efficient market

Active investment strategies cannot earn the positive risk-adjusted return consistently.

Thus, investors should therefore use a passive strategy.

Market value vs. Intrinsic value

Market value

Intrinsic value

Factors affecting market efficiency

Make market more efficient

Make market less efficient

Market efficiency forms

Weak-form
MAIN

Semi-strong-form

Strong-form

Market Anomalies

Security price fully reflect all information about past price and volume

Technical analysis does not consistently result in abnormal profits

Security price fully reflect all publicity available information

Fundamental analysis does not consistently result in abnormal profit; however they are necessary if market prices are to be semi-strong-form efficient.

Security price fully reflect all private and public information

Active investment management does not consistently result in abnormal profit.

Roles for Portfolio Managers

Investors CANNOT use information to earn positive abnormal (risk-adjusted) return on average

The price that investors with full knowledge of asset characteristics would place on the asset.

Price at which it can be bought or sold

If markets are not efficient, market values will differ from intrinsic value in predictable ways

Larger numbers of market participants

Greater information availability

Impediment to arbitrage, short-selling

High costs of trading & gathering information

Establish portfolio risk/return objectives

Portfolio diversification

Implement asset allocation based on risk/return objectives

Tax minimization

Anomalies are observed market inefficiencies - evidence of predictable risk-adjusted returns

Anomalies by research method:

Time series anomalies

Cross-sectional

Other

Calendar effects: January (tax-loss selling, window dressing), turn-of-month, day-of-week, weekend, holiday

Overreaction: Prices inflated after good news, depressed after bad news - losers beat winners

Momentum: High short-term returns continue in following periods - may be rational reaction

Size effect: Small-cap stocks outperform large-cap stocks - sensitive to time period

Value effect: Low P/E, low P/B, high dividend yield stock outperform - disappears with Fama and French model

slow adjustment to earnings surprises

IPOs: Initial overreaction, long-term underperformance

Anomaly Evidence

Most evidence appears to result from methodology used

Many anomalies are not profitable when transactions costs are considered

Some strategies have ceased to work overtime

Some strategies only work in some time periods

Portfolio management should not be based on anomalies with no economic basis

Behavior finance

Investors behave in ways that are not rational

Investors have cognitive biases

Loss aversion

Risk aversion is asymmetrical

Investors dislike losses more than they like gains

Overconfidence

Investors overestimate their ability to value securities

Gambler's fallacy

Recent results affect estimates of future probabilities (don't wanna quit while on a streak)

Information cascades

Uninformed investors mimic actions of informed investors

Investor irrationality due to cognitive bias does NOT necessarily mean that rational investor can "beat the market"

Market can still be efficient despite of irrationality in some investors

Market Inefficiency: Ngược lại của Efficient tại từng mức độ