Efficient Markets & Behavioral Finance (To understand…
Tests of Market Efficiency
- event studies
- record of professional managers
Market Efficiency EvidenceThe Weak Form
The Semi-strong Form
- Reported serial correlation coefficients are quite small
- Price appear to follow random walk
The Strong form
- Price tend to react quickly to new information
- Fund manager tend to underperform broad market
- Suggests that insider trading would be unprofitable
- Obviously untrue
The Behavioral Challenge to Market EfficiencyEfficiency is built on investor rationality, independence, and arbitrage; however Behavioral finance suggests that investors deviate from these assumptions in predictable ways.
As such, efficiency may not hold. A primary example is speculative bubbles
- Representativeness: investors draw conclusions from too little data, or overweight the results of small samples
- Conservatism: investors adjust their beliefs too slowly to new information
Empirical Challenges to Market Efficiency
- small stocks tend to outperform large stocks
- value stocks tend to outperform growth stocks
- investors appear to react slowly to earnings announcements
- arbitrage has transactional limits
- the existence of bubbles and crashes is inconsistent with efficiency
Implications for Corporate Finance
- firms should expect to receive the fair value (i.e., present value) for securities they issue
- stock price do not react to accounting method changes.
- negative abnormal returns follow issuance of new equity.
- positive abnormal returns follow repurchase of equity.
- positive NPV projects will be "few and far-between"
Information is knowledge about the probability of events
We have a certain view of the world (probabilities) and then new information arrives. Based on the new information, we update our beliefs. This is especially relevant to the stock market as investors have beliefs about the future prices of stocks which they update as new information arrives in the form of earnings reports, product announcements, etc
- The legal version is when corporate insiders—officers, directors, and employees—buy and sell stock in their own companies. When corporate insiders trade in their own securities, they must report their trades to the SEC.
- Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include "tipping" such information, securities trading by the person "tipped," and securities trading by those who misappropriate such information."