U. I4. Market Efficiency PDF

2/13/2018
Financial Investments
Market Efficiency
Objectives
• What makes stock prices move?

• What is random walk theory?
• What is market efficiency?
• What are the different implications of “Market
Efficiency Hypothesis”?
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Market Efficiency
Contents of Stock Prices
• Suppose that you have figured out the following

pattern in stock prices:
– Buy stock XYZ, if it has been rising for more than 2/3 of
the times during the past month.
– Sell stock XYZ, if it has been falling for more than 2/3 of
the times during the past month.
– And if you follow this rule strictly, you will earn
“abnormally high” return.
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• If you have spotted a pattern that guarantees you

pure profit (for example, the pattern described in
the previous slide), what should you do?
• You should exploit this opportunity by borrowing

as much as you can and investing in the stock or
short selling as much as you can.
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• What will happen if you exploit the opportunity

that guarantees you pure profit?
• The process of exploiting the opportunity will

make the opportunity vanish.
• In case of previous example, you would bid up
XYZ’s price when you think it is hot, and you
would also bid down XYZ’s price when you think it
is cold.
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Investor behavior tends to eliminate any profit

opportunity that is associated with stock price
patterns.
Stock Price
If it were possible to
Sell
make big money simply
Sell by finding “the pattern” in
the stock price
Buy movements, everyone
would do it and the
Buy
profits would be
competed away.
Time
• In short, the fact that you have figured out a stock

price movement is very likely to be reflected by
the stock price.
• The more greedy you are, the faster the stock price
pattern will be eliminated.
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• Imagine not only you, there exists an “army” of

intelligent, well-informed security analysts and
traders, who literally spend their lives hunting for
securities which are mispriced.
• They have high-tech computers, subscription to

professional database, up-to-date information on
thousands of firms, and state-of-the-art analytical
techniques. These people can assess, assimilate
and act on information very quickly.
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• In their intense search for mispriced securities,

professional investors may “police” the market so
efficiently that they drive the prices of all assets
to fully reflect all available information.
• Competition for finding mispriced securities is

fierce. Such competition always kills the “sure-
profit” pattern because if there was any, it would
have been exploited by someone who first spotted
it and it would have eventually resulted in
eliminating any profit.
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• The implications for such a behavior is that stock

prices should reflect all available information
at the time you trade.
• In other words, stock prices and markets should
be efficient.
Market Efficiency
Random Walk Theory
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Random Walk Theory
• One of the implications of previous discussion is

that it should be difficult to predict the prices.
• That is, if “all available information” is already
incorporated in prices, the movement of future
prices should be contingent upon the arrival of
new information.
Random Walk Theory
• Therefore, if stock price changes, it should be

reacting only to “new information”. The fact that
information is new means stock prices are
unpredictable.
• This is the essence of the argument that stock
prices should follow a random walk. That is,
price changes should be random and
unpredictable.
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Random Walk Theory

Divergence…
• An example of random walk is a walk of drunk

man. If asked to walk on a straight line, he may not
be able to put his feet on the line consistently.
Sometimes, he may be above and sometimes
below the line. It is hard to predict the walk of a
drunk man.
Random Walk Theory
• An important empirical evidence that can be cited

to support that price changes are random and
unpredictable is the following: There is no
correlation between the returns of two
consecutive weeks or between the returns of
two consecutive months on any major stock
market index.
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Random Walk Theory
• Scatter plot of returns of NYSE Composite Index

over two successive weeks is shown below.
Random Walk Theory
• Previous figure shows no correlation between

returns of two successive weeks.
• It indicates that it is hard to predict prices based
on information that is already incorporated in
prices.
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Random Walk Theory
• The Random Walk Theory suggests that stock

prices change randomly without any predictable
trends or patterns.
• It states that the past movement of price of a stock
or overall market cannot be used to predict its
future movement.
Random Walk Theory
• According to the Random walk theory, the chance

of a stock’s future price going up is the same as it
going down.
• A follower of random walk believes it is
impossible to outperform the market without
obtaining additional information.
• Random walk has never been a popular concept
with those working in stock markets.
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Market Efficiency
Market Efficiency
Market Efficiency
• The notion that prices reflect all information gives

rise to the concept of market efficiency.
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Market Efficiency
• However, a casual observation of the stock market

suggests that prices never reflect all information.
There is always some information that is not
incorporated in prices.
• Therefore, markets are not strictly efficient. There
is always some degree of inefficiency.
Market Efficiency
• The degree of efficiency (or inefficiency) is a

function of unincorporated information.
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Market Efficiency
• The information that needs to be incorporated

falls under three broad categories:
– Historic Information
– Public Information
– Private Information
Market Efficiency
• The extent of incorporation of each category of

information will define the degree of efficiency.
• The degree of efficiency (or inefficiency) can be
classified into the following types:
– Weak-form Efficiency
– Semi-strong-form Efficiency
– Strong-form Efficiency
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Market Efficiency
• In weak-form efficiency, “stock prices are

assumed to reflect any information that may be
contained in the past history of the stock price”.
Market Efficiency
• As an example, suppose that there exists a

seasonal pattern in stock prices such that stock
prices fall on the last trading day of the year and
then rise on the first trading day of the following
year.
• Under the weak-form of the hypothesis, the
market will come to recognize this and price the
phenomenon away.
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Market Efficiency
• Anticipating the rise in price on the first day of the

year, traders will attempt to get in at the very start
of trading on the first day. Their attempts to get in
will cause the increase in price to occur in the first
minutes of the first day.
Market Efficiency
• Intelligent traders will, then, recognize that to beat

the rest of the market, they will have to get in late
on the last day. The consequences, therefore, is the
elimination of the pattern as price in the last
trading day will increase.
• This implies that past rates of return and other
market data should have no relationship with
future rates of return.
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Market Efficiency
• In semi-strong-form efficiency, “stock prices are

assumed to reflect any information that is publicly
available”.
Market Efficiency
Divergence…
• Publicly available information may include the

following:
– Information on stock price series
– Information in firm’s accounting reports
– Information in reports of competing firms
– Announced information relating to the state of economy
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Market Efficiency
• In order to understand semi-strong-form

efficiency, assume that a firm is being acquired by
another firm.
• There exists an evidence that stock prices of
acquired firms increase on the day of
announcement of acquisition.
Market Efficiency
• Under the semi-strong-form efficiency, the market

will come to recognize this and price the
phenomenon away.
• That is, everyone will buy the stock as soon as the
information is out and it would be impossible to
make profit.
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Market Efficiency
• This implies that decisions made on new

information after it is public should not lead to
above-average risk-adjusted profits from those
transactions.
Market Efficiency
• In strong-form efficiency, “stock prices are

assumed to reflect all information, regardless of
them being public or private”.
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Market Efficiency
• Under this form, those who acquire insider

information act on it (buying or selling the stock).
Their actions affect the price of stock, and the
price quickly adjusts to reflect the insider
information.
• This implies that no group of investors should
be able to consistently derive above-average
risk-adjusted rates of return.
Market Efficiency
• We can summarize our previous discussion in the

following figure:
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Market Efficiency
Implications of Market Efficiency
Implication of Market Efficiency
• Major implication of stock market efficiency is that

no investor will be able to consistently beat the
market.
• That is, no investor will be able to consistently
earn returns that are greater than the returns of
market.
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• In order to elaborate this fact, consider that

investors attempt to beat the market by using the
following techniques:
– Technical Analysis
– Fundamental Analysis

Technical Analysis
• Technical analysts forecast stock prices based on

watching the fluctuations in historical prices.
• Technical analysts identify non-random price
patterns and trends in financial markets and
attempt to exploit those patterns. For example,
they might hope to beat the market by buying the
stock that is increasing in price and selling that is
declining in price.
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Technical Analysis
• Unfortunately such simple rules do not work.

There is no correlation between the returns of two
consecutive weeks, for example, for New York
Composite Index. Correlation between the returns
of two consecutive weeks is -0.012 (almost zero).
• Same result is observed for correlation between
the returns of two consecutive months for New
York Composite Index. Correlation between the
returns of two consecutive weeks is -0.03 (almost
zero).

Technical Analysis
• Following figure
highlights no
patterns in the
scatter plot of
NYSE Composite
Index over two
successive
weeks.
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Technical Analysis
• Given that there is no correlation between prices,

it is hard to find any patterns in stock prices.
• Therefore, technical analysis becomes
ineffective in efficient markets. You will not be
able to gain abnormal returns based on it.

Technical Analysis
• Another illustration of why technical analysis is

ineffective in efficient markets can be observed in
some of the basic decision making beliefs of
technical analysts.
• Most of technical analysts believe that stock prices
cannot rise above a certain level (resistance level)
and fall below a certain level (support level).
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Technical Analysis
• If we assume that the market believes that $72 is a

resistance level for stock, no one would be willing
to purchase the stock at a price of $71.50, because
it would have almost no room to increase in price,
but ample room to fall.

Technical Analysis
• We can argue that, if no one would buy it at

$71.50, then $71.50 would become a resistance
level. Using a similar argument would imply that
no one would buy it at $71, or $70, and so on.
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Technical Analysis
• The notion of a resistance or support level is hard

to explain under efficient markets.
• It is because if the stock is ever to sell at $71.50,
investors must believe that the price can as easily
increase as fall. The fact that investors are willing
to purchase (or even hold) the stock at $71.50 is
evidence of their belief that they can earn a fair
expected rate of return at that price.

Fundamental Analysis
• Fundamental analysts attempt to find mispriced

stocks by analyzing the fundamental information
(such as, the accounting data and the business
prospects).
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• Fundamental analysts maintain that markets may

misprice a stock in the short-run but that the
“correct” price will eventually be reached.
• They believe that profits can be made by trading
the mispriced security and then waiting for the
market to recognize its “mistake” and re-price the
security.

• Similar to technical analysis, fundametal analysis

may not help you beat the market.
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• As an illustration, assume that you buy a stock

whenever a favorable information comes and sell
a stock whenever unfavourable information pops
up.
• Also assume that you come across a firm that is a
subject to takeover from another firm. In most
takeovers, acquirer firm pays huge premium to
shareholders of target firm. In response to these
premums, prices of target firm increase.

• If you buy a stock at any takeover news, you will

not make profits because prices react
instantaneously to the takeover news.
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• Next figure shows that, on the day the takeover

news is made public, prices of the target firm take
a big jump and prices are adjusted at new level
immediately.

• Therefore, if semi-strong form of market

efficiency is valid, no analysis will help you
attain abnormal returns as long as the analysis
is based on publicly available information.
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• Furthermore, if strong-form of market

efficiency is valid, any effort to seek out insider
information to beat the market are also
ineffective because the price will reflect the
insider information before any trade is made.
• Under this form of market efficiency, no form of
search or processing of information will
consistently produce abnormal returns.
• An important question that arises from our

previous discussion is: If markets are efficient,
why should we spend time on portfolio
management? What is the value for portfolio
management?
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• The answer that we need to have a well-

diversified portfolio that is tailored towards our
risk-preference.
• Depending on our age, our risk-preference, our
current financial situation, and our tax bracket,
our portfolio should be carefully constructed. We
require a competent portfolio manager to conduct
these tasks.
• Also do not forget that there is value for you to

tailor a future payoff profile specific to your own
needs. Randomly picking stocks does not
guarantee that your specific needs are met.
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• Efficiency of stock market does not imply that the

knowledge of finance is useless. In finance, we
have learnt diversification and portfolio theory,
which is based on maximizing utility. Everyone’s
utility can be maximized in different ways.
Market Efficiency
Stock Market Anomalies
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• It is generally accepted that stock markets are

efficient. However, there are some phenomenon
that cannot be explained by this theory.
• Some of the stock market behaviors that

contradict efficient market are as follows:
– Earnings Announcement Puzzle
– New Issue Puzzle
– Weekend Effect
– January Effect
– Cyclicality of Returns
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Earnings Announcement Puzzle
• In an efficient stock market, a firm’s stock price

should react instantaneously to any unexpected
news. However, it has been documented that there
is a tendency for stocks to earn abnormally high
returns in periods following a positive earnings
announcement, and to earn abnormally low
returns in periods following a negative earnings
announcement.

New Issue Puzzle
• Firms conducting new issues perform worse on

average than the other firms during the post-issue
years.
• Loughran and Ritter (1995) argue investor lose
30% over five years investing in an SEO. Similar
results have been obtained for IPO.
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Weekend Effect
• Weekend effect discusses how small-cap stocks

tend to rise on Fridays and fall on Mondays.

January Effect
• January effect is a general increase in stock prices

during the month of January.
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Cyclicality of Returns
• DeBondt and Thaler (1985) show that best

performers over the preceding 5 and 3 years
subsequently underperformed, while the poor
performers from the prior period produced
significantly greater returns than the NYSE index.
Market Efficiency
Contentious Issues in Market

Efficiency
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Contentious Issues in Market Efficiency
• Market efficiency implies that a great deal of the

activity of portfolio managers – the search for
undervalued securities – is a wasted effort, and
quite probably harmful to clients because it costs
money.
• Efficient market hypothesis, therefore, has never
been accepted by professional investment
managers.
• Opposition to market efficiency involves around

the following issues:
– Selection Bias Issue
– Lucky Event Issue
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Selection Bias Issue
• Suppose that you discover an investment scheme

that could really make money. You have two
choices:
– Publish your technique in The Wall Street Journal and
earn fame
– Keep your technique secret and use it to earn millions
of dollars

• Most investors would keep the investment scheme

secret.
• Only those investors who find that an investment
scheme cannot generate abnormal returns will be
willing to report their findings to the whole world.
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• Hence, opponents of the efficient markets can

argue that techniques that do work are not being
reported to the public. While, those that do not
work are reported.
• This is a problem in selection bias – the outcomes
we are able to observe have been pre-selected in
favor of failed attempts. Therefore, we cannot
fairly evaluate the true ability of investors to
outperform the market.

Lucky Event Issue
• In almost every month, we read an article about

some investor with a fantastic investment
performance over the recent past. The superior
records of such investors can be used to disprove
the efficient market hypothesis.
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Lucky Event Issue
• However, this conclusion is far from obvious.

Lucky Event Issue
• Under the hypothesis that any stock is fairly

priced given all available information, any bet on a
stock is simply a coin toss. There is equal
likelihood of winning or losing the bet.
• However, if many investors using a variety of
strategies make fair bets, some of those investors
will be lucky and win a great majority of the bets.
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Lucky Event Issue: Example 1
• Suppose you observe the investment performance

of 350 portfolio managers for 5 years and rank
them by investment returns during each year.
After 5 years, you find that 11 of the funds have
investment returns that place the fund in the top
half of the sample in each and every year of your
sample. Such consistency of performance indicates
to you that these must be the funds whose
managers are skilled, and you invest your money
in these funds. Is your conclusion correct?

• Suppose that finishing in the top half of all

portfolio managers is purely luck, and that the
probability of doing so in any year is exactly ½.
• The probability that any particular manager would
finish in the top half of the sample five years in a
row is (½)5 = 1/32.
• We can, therefore, expect to find that 11 managers
[=350 * (1/32)] finish in the top half for each of
the five consecutive years.
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• This is precisely what we found. Thus, we should

not conclude that the consistent performance after
five years is a proof of skill.
• We would expect to find 11 managers exhibiting
precisely this level of "consistency" even if
performance is due solely to luck.
Market Efficiency
References
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References
• Bodie, Z., Kane, A., and Marcus, A.J., (2013).

Essentials of Investments (Chapter 8). 9th Edition,
McGraw-Hill/Irwin.
44

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2/13/2018

• What makes stock prices move?

Contents of Stock Prices

Contents of Stock Prices

• Suppose that you have figured out the following

Contents of Stock Prices

• If you have spotted a pattern that guarantees you

Contents of Stock Prices

• You should exploit this opportunity by borrowing

Contents of Stock Prices

• What will happen if you exploit the opportunity

Contents of Stock Prices

• The process of exploiting the opportunity will

Contents of Stock Prices

Investor behavior tends to eliminate any profit

Contents of Stock Prices

• In short, the fact that you have figured out a stock

Contents of Stock Prices

• Imagine not only you, there exists an “army” of

Contents of Stock Prices

• They have high-tech computers, subscription to

Contents of Stock Prices

• In their intense search for mispriced securities,

Contents of Stock Prices

• Competition for finding mispriced securities is

Contents of Stock Prices

• The implications for such a behavior is that stock

Random Walk Theory

Random Walk Theory

• One of the implications of previous discussion is

Random Walk Theory

• Therefore, if stock price changes, it should be

Random Walk Theory

• An example of random walk is a walk of drunk

Random Walk Theory

• An important empirical evidence that can be cited

Random Walk Theory

• Scatter plot of returns of NYSE Composite Index

Random Walk Theory

• Previous figure shows no correlation between

Random Walk Theory

• The Random Walk Theory suggests that stock

Random Walk Theory

• According to the Random walk theory, the chance

• The notion that prices reflect all information gives

• However, a casual observation of the stock market

• The degree of efficiency (or inefficiency) is a

• The information that needs to be incorporated

• The extent of incorporation of each category of

• In weak-form efficiency, “stock prices are

• As an example, suppose that there exists a

• Anticipating the rise in price on the first day of the

• Intelligent traders will, then, recognize that to beat

• In semi-strong-form efficiency, “stock prices are

• Publicly available information may include the

• In order to understand semi-strong-form

• Under the semi-strong-form efficiency, the market

• This implies that decisions made on new

• In strong-form efficiency, “stock prices are

• Under this form, those who acquire insider

• We can summarize our previous discussion in the

Implications of Market Efficiency

Implication of Market Efficiency