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CHAPTER8:EFFICIENTMARKETS

ANDTHEBEHAVIORALCRITIQUE

1. Theassumptionsconsistentwithefficientmarketsare(a)and(c).Many
independent,profitmaximizingparticipants[statement(a)]leadstoefficient
markets.Statement(c)isaconsequenceofthefactthatmarketsareefficient.

2. c. Thisisapredictablepatterninreturns,whichshouldnotoccurifthestock
marketisweaklyefficient.

3. b. Thisisthedefinitionofanefficientmarket.

4. Thecorrelationcoefficientshouldbezero.Ifitwerenotzero,thenonecould
usereturnsfromoneperiodintheU.K.topredictreturnsinlaterperiodsin
Japanandthereforeearnabnormalprofits.

5. c. Thisisaclassicfilterrule,whichwouldappeartocontradicttheweakformof
theefficientmarkethypothesis.

6. No,thisisnotaviolationoftheEMH.Toyotascontinuinglargeprofitsdonot
implythatstockmarketinvestorswhopurchasedToyotasharesafteritssuccess
alreadywasevidentwouldhaveearnedahighreturnontheirinvestments.

7. Overthelonghaul,thereisanexpectedupwarddriftinstockpricesbasedontheir
fairexpectedratesofreturn.Thefairexpectedreturnoveranysingledayisvery
small(e.g.,12%peryearisonlyabout0.03%perday),sothatonanydaytheprice
isvirtuallyequallylikelytoriseorfall.However,overlongerperiods,thesmall
expecteddailyreturnscumulate,andupwardmovesareindeedmorelikelythan
downwardones.

8. Youshouldbuythestock.Inyourview,thefirmsmanagementisnotasbadas
everyoneelsebelievesittobe.Therefore,youviewthefirmasundervaluedbythe
market.Youarelesspessimisticaboutthefirmsprospectsthanthebeliefsbuilt
intothestockprice.

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9. No,thisisnotaviolationoftheEMH.Thisempiricaltendencydoesnotprovide
investorswithatoolthatwillenablethemtoearnabnormalreturns;inotherwords,
itdoesnotsuggestthatinvestorsarefailingtouseallavailableinformation.An
investorcouldnotusethisphenomenontochooseundervaluedstockstoday.The
phenomenoninsteadreflectsthefactthatstocksplitsoccurasaresponsetogood
performance(i.e.,positiveabnormalreturns)whichdrivesupthestockpriceabove
adesired"tradingrange"andthenleadsmanagerstosplitthestock.Afterthefact,
thestocksthathappentohaveperformedthebestwillbesplitcandidates,butthis
doesnotimplythatyoucanidentifythebestperformersearlyenoughtoearn
abnormalreturns.

10. Whilepositivebetastocksrespondwelltofavorablenewinformationaboutthe
economysprogressthroughthebusinesscycle,theseshouldnotshowabnormal
returnsaroundalreadyanticipatedevents.Ifarecovery,forexample,isalready
anticipated,theactualrecoveryisnotnews.Thestockpriceshouldalreadyreflect
thecomingrecovery.

11. Expectedratesofreturndifferbecauseofdifferentialriskpremiums.

12. Themarketrespondspositivelytonewnews.Iftheeventualrecoveryis
anticipated,thentherecoveryisalreadyreflectedinstockprices.Onlyabetter
thanexpectedrecovery(oraworsethanexpectedrecovery)shouldaffectstock
prices.

13. d.

14. c. TheP/Eratioispublicinformationsothisobservationwouldprovide
evidenceagainstthesemistrongformoftheefficientmarkettheory.

15. Assumptionssupportingpassivemanagementare:
a.informationalefficiency
b.primacyofdiversificationmotives
Activemanagementissupportedbytheoppositeassumptions,inparticular,that
pocketsofmarketinefficiencyexist.

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16. a. Thegrandsonisrecommendingtakingadvantageof(i)thesmallfirmanomaly
and(ii)theJanuaryanomaly.Infact,thisseemstobeoneanomaly:thesmall
firminJanuaryanomaly.

b. (i)Concentrationofonesportfolioinstockshavingverysimilarattributes
mayexposetheportfoliotomoreriskthanisdesirable.Thestrategylimits
thepotentialfordiversification.
(ii)Evenifthestudyresultsarecorrectasdescribed,eachsuchstudycovers
aspecifictimeperiod.Thereisnoassurancethatfuturetimeperiodswould
yieldsimilarresults.
(iii)Aftertheresultsofthestudiesbecamepubliclyknown,investmentdecisions
mightnullifytheserelationships.Ifthesefirmsinfactofferedinvestment
bargains,theirpricesmaybebiduptoreflectthenowknownopportunity.

17. a. Consistent.Halfofallmanagersshouldoutperformthemarketbasedonpure
luckinanyyear.

b. Violation.Thiswouldbethebasisforan"easymoney"rule:simplyinvest
withlastyear'sbestmanagers.

c. Consistent.Predictablevolatilitydoesnotconveyameanstoearnabnormal
returns.

d. Violation.TheabnormalperformanceoughttooccurinJanuary,whenthe
increasedearningsareannounced.

e. Violation.Reversalsofferameanstoearneasymoney:simplybuylast
week'slosers.

18. Implicitinthedollarcostaveragingstrategyisthenotionthatstockpricesfluctuate
aroundanormallevel.Otherwise,thereisnomeaningtostatementssuchas:when
thepriceishigh.Howdoweknow,forexample,whetherapriceof$25todaywill
beviewedashighorlowcomparedtothestockpriceinsixmonthsfromnow?

19. a. Theefficientmarkethypothesis(EMH)statesthatamarketisefficientifsecurity
pricesimmediatelyandfullyreflectallavailablerelevantinformation.Ifthe
marketfullyreflectsinformation,theknowledgeofthatinformationwouldnot
allowaninvestortoprofitfromtheinformationbecausestockpricesalready
incorporatetheinformation.

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i.TheweakformoftheEMHassertsthatstockpricesreflectalltheinformation
thatcanbederivedbyexaminingmarkettradingdatasuchasthehistoryofpast
pricesandtradingvolume.
AstrongbodyofevidencesupportsweakformefficiencyinthemajorU.S.
securitiesmarkets.Forexample,testresultssuggestthattechnicaltradingrules
donotproducesuperiorreturnsafteradjustingfortransactioncostsandtaxes.
ii.Thesemistrongformstatesthatafirmsstockpricereflectsallpublicly
availableinformationaboutafirmsprospects.Examplesofpubliclyavailable
informationarecompanyannualreportsandinvestmentadvisorydata.
Evidencestronglysupportsthenotionofsemistrongefficiency,butoccasional
studies(e.g.,thoseidentifyingmarketanomaliessuchasthesmallfirmin
Januaryorbooktomarketeffects)andevents(suchasthestockmarketcrash
ofOctober19,1987)areinconsistentwiththisformofmarketefficiency.
However,thereisaquestionconcerningtheextenttowhichtheseanomalies
resultfromdatamining.
iii.ThestrongformoftheEMHholdsthatcurrentmarketpricesreflectall
information(whetherpubliclyavailableorprivatelyheld)thatcanberelevant
tothevaluationofthefirm.
Empiricalevidencesuggeststhatstrongformefficiencydoesnothold.Ifthis
formwerecorrect,priceswouldfullyreflectallinformation.Thereforeeven
insiderscouldnotearnexcessreturns.Buttheevidenceisthatcorporate
officersdohaveaccesstopertinentinformationlongenoughbeforepublic
releasetoenablethemtoprofitfromtradingonthisinformation.

b. i.Technicalanalysisinvolvesthesearchforrecurrentandpredictablepatternsin
stockpricesinordertoenhancereturns.TheEMHimpliesthattechnicalanalysis
iswithoutvalue.Ifpastpricescontainnousefulinformationforpredictingfuture
prices,thereisnopointinfollowinganytechnicaltradingrule.
ii.Fundamentalanalysisusesearningsanddividendprospectsofthefirm,
expectationsoffutureinterestrates,andriskevaluationofthefirmtodetermine
properstockprices.TheEMHpredictsthatmostfundamentalanalysisisdoomed
tofailure.Accordingtosemistrongformefficiency,noinvestorcanearnexcess
returnsfromtradingrulesbasedonpubliclyavailableinformation.Onlyanalysts
withuniqueinsightachievesuperiorreturns.
Insummary,theEMHholdsthatthemarketappearstoadjustsoquicklyto
informationaboutbothindividualstocksandtheeconomyasawholethatno
techniqueofselectingaportfoliousingeithertechnicalorfundamentalanalysis
canconsistentlyoutperformastrategyofsimplybuyingandholdingadiversified
portfolioofsecurities,suchasthosecomprisingthepopularmarketindexes.

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c. Portfoliomanagershaveseveralrolesandresponsibilitieseveninperfectly
efficientmarkets.Themostimportantresponsibilityistoidentifythe
risk/returnobjectivesforaportfoliogiventheinvestorsconstraints.Inan
efficientmarket,portfoliomanagersareresponsiblefortailoringtheportfolioto
meettheinvestorsneeds,ratherthantobeatthemarket,whichrequires
identifyingtheclientsreturnrequirementsandrisktolerance.Rational
portfoliomanagementalsorequiresexaminingtheinvestorsconstraints,
includingliquidity,timehorizon,lawsandregulations,taxes,andunique
preferencesandcircumstancessuchasageandemployment.

20. a. Theearnings(anddividend)growthratesofgrowthstocksmaybeconsistently
overestimatedbyinvestors.Investorsmayextrapolaterecentearnings(and
dividend)growthtoofarintothefutureandtherebydownplaytheinevitable
slowdown.Atanygiventime,growthstocksarelikelytorevertto(lower)
meanreturnsandvaluestocksarelikelytorevertto(higher)meanreturns,
oftenoveranextendedfuturetimehorizon.

b. Inefficientmarkets,thecurrentpricesofstocksalreadyreflectallknown,
relevantinformation.Inthissituation,growthstocksandvaluestocksprovide
thesameriskadjustedexpectedreturn.

21. a. SomeempiricalevidencethatsupportstheEMHis:
(i) professionalmoneymanagersdonottypicallyearnhigherreturnsthan
comparablerisk,passiveindexstrategies;
(ii) eventstudiestypicallyshowthatstocksrespondimmediatelytothepublic
releaseofrelevantnews;
(iii) mosttestsoftechnicalanalysisfindthatitisdifficulttoidentifypricetrends
thatcanbeexploitedtoearnsuperiorriskadjustedinvestmentreturns.

b. SomeevidencethatisdifficulttoreconcilewiththeEMHconcernssimple
portfoliostrategiesthatapparentlywouldhaveprovidedhighriskadjustedreturns
inthepast.Someexamplesofportfolioswithattractivehistoricalreturns:
(i) lowP/Estocks;
(ii) highbooktomarketratiostocks;
(iii) smallfirmsinJanuary;
(iv) firmswithverypoorstockpriceperformanceinthelastfewmonths.
Otherevidenceconcernspostearningsannouncementstockpricedriftand
intermediatetermpricemomentum.

c. Aninvestormightchoosenottoindexevenifmarketsareefficientbecauseheor
shemaywanttotailoraportfoliotospecifictaxconsiderationsortospecificrisk

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managementissues,forexample,theneedtohedge(oratleastnotaddto)
exposuretoaparticularsourceofrisk(e.g.,industryexposure).

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22. No,itisnotmoreattractiveasapossiblepurchase.Anyvalueassociatedwith
dividendpredictabilityisalreadyreflectedinthestockprice.

23. Themarketmayhaveanticipatedevengreaterearnings.Comparedtoprior
expectations,theannouncementwasadisappointment.

24. i. MentalaccountingisbestillustratedbyStatement#3.Sampsonsrequirement
thathisincomeneedsbemetviainterestincomeandstockdividendsisan
exampleofmentalaccounting.Mentalaccountingholdsthatinvestors
segregatefundsintomentalaccounts(e.g.,dividendsandcapitalgains),
maintainasetofseparatementalaccounts,anddonotcombineoutcomes;a
lossinoneaccountistreatedseparatelyfromalossinanotheraccount.
Mentalaccountingleadstoaninvestorpreferencefordividendsovercapital
gainsandtoaninabilityorfailuretoconsidertotalreturn.

ii. Overconfidence(illusionofcontrol)isbestillustratedbyStatement#6.
Sampsonsdesiretoselectinvestmentsthatareinconsistentwithhisoverall
strategyindicatesoverconfidence.Overconfidentindividualsoftenexhibit
riskseekingbehavior.Peoplearealsomoreconfidentinthevalidityoftheir
conclusionsthanisjustifiedbytheirsuccessrate.Causesofoverconfidence
includetheillusionofcontrol,selfenhancementtendencies,insensitivityto
predictiveaccuracy,andmisconceptionsofchanceprocesses.

iii. ReferencedependenceisbestillustratedbyStatement#5.Sampsonsdesire
toretainpoorperforminginvestmentsandtotakequickprofitsonsuccessful
investmentssuggestsreferencedependence.Referencedependenceholdsthat
investmentdecisionsarecriticallydependentonthedecisionmakers
referencepoint.Inthiscase,thereferencepointistheoriginalpurchaseprice.
Alternativesareevaluatednotintermsoffinaloutcomesbutratherintermsof
gainsandlossesrelativetothisreferencepoint.Thus,preferencesare
susceptibletomanipulationsimplybychangingthereferencepoint.

25. a. Frost's statement is an example of reference dependence. His inclination to sell the
international investments once prices return to the original cost depends not only on
the terminal wealth value, but also on where he is now, that is, his reference point.
This reference point, which is below the original cost, has become a critical factor
in Frosts decision.
In standard finance, alternatives are evaluated in terms of terminal wealth values or
final outcomes, not in terms of gains and losses relative to some reference point
such as original cost.

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b. Frostsstatementisanexampleofsusceptibilitytocognitiveerror,inatleast
twoways.First,heisdisplayingthebehavioralflawofoverconfidence.He
likelyismoreconfidentaboutthevalidityofhisconclusionthanisjustifiedby
hisrateofsuccess.HeisveryconfidentthatthepastperformanceofCountry
XYZindicatesfutureperformance.Behavioralinvestorscould,andoftendo,
concludethatafiveyearrecordisampleevidencetosuggestfuture
performance.Second,bychoosingtoinvestinthesecuritiesofonlyCountry
XYZ,Frostisalsoexemplifyingthebehavioralfinancephenomenonofasset
segregation.Thatis,heisevaluatingCountryXYZinvestmentintermsofits
anticipatedgainsorlossesviewedinisolation.
Individuals are typically more confident about the validity of their conclusions
than is justified by their success rate or by the principles of standard finance,
especially with regard to relevant time horizons. In standard finance, investors
know that five years of returns on Country XYZ securities relative to all other
markets provide little information about future performance. A standard
finance investor would not be fooled by this law of small numbers. In
standard finance, investors evaluate performance in portfolio terms, in this case
defined by combining the Country XYZ holding with all other securities held.
Investments in Country XYZ, like all other potential investments, should be
evaluated in terms of the anticipated contribution to the risk- reward profile of
the entire portfolio.

c. Frostsstatementisanexampleofmentalaccounting.Mentalaccounting
holdsthatinvestorssegregatemoneyintomentalaccounts(e.g.,safeversus
speculative),maintainasetofseparatementalaccounts,anddonotcombine
outcomes;alossinoneaccountistreatedseparatelyfromalossinanother
account.Onemanifestationofmentalaccounting,inwhichFrostisengaging,
isbuildingaportfolioasapyramidofassets,layerbylayer,withthe
retirementaccountrepresentingalayerseparatefromthespeculativefund.
Eachlayerisassociatedwithdifferentgoalsandattitudestowardrisk.Heis
moreriskaversewithrespecttotheretirementaccountthanheiswithrespect
tothespeculativefundaccount.Themoneyintheretirementaccountisa
downsideprotectionlayer,designedtoavoidfuturepoverty.Themoneyin
thespeculativefundaccountistheupsidepotentiallayer,designedfora
chanceatbeingrich.
Instandardfinance,decisionsconsidertheriskandreturnprofileoftheentire
portfolioratherthananticipatedgainsorlossesonanyparticularaccount,
investment,orclassofinvestments.Alternativesshouldbeconsideredin
termsoffinaloutcomesinatotalportfoliocontextratherthanintermsof
contributionstoasafeoraspeculativeaccount.Standardfinance
investorsseektomaximizethemeanvariancestructureoftheportfolioasa
wholeandconsidercovariancesbetweenassetsastheyconstructtheir
portfolios.Standardfinanceinvestorshaveconsistentattitudestowardrisk
acrosstheirentireportfolio.

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