1- 1

Behavioral Finance

Chapter 4
Challenges to
Market Efficiency

1
 1- 2

Introduction
Early tests of market efficiency were largely
positive
However, more recent empirical evidence has
uncovered a series of anomalies.
– Efficiency tests are by their very nature joint
hypothesis tests
– Market efficiency and a particular risk-adjustment
technique together constitute the maintained
hypothesis

2
 1- 3

Introduction (cont.)
Because there are significant limits to
arbitrage, not all mispricing need
disappear quickly.
– Arbitrage involves the simultaneous purchase
and sale (or short-sale) of securities so as to
lock in a risk-free profit

3
 1- 4

Introduction (cont.)
These limits stem from
– 1) noise-trader risk: the possibility that
mispricing worsens in the short-run
– 2) fundamental risk: it exists when the
substitute security is an imperfect substitute
– 3) implementation costs: trading costs and the
potential non-availability of the security that
must be short-sold

4
 1- 5

Some Key Anomalies

1. Lagged reactions to earnings announcements

2. The small-firm effects

3. Value vs. growth

4. Momentum and reversal

5
 Lagged reactions to earnings 1- 6

announcements
Event study methodology
– Look at a large number of similar events for a
comprehensive sample of firms; work in terms of
event-time rather than calendar-time
– Calculate excess returns on days leading up to the
event, on the day of the event, and on days after the
event
– Average these excess returns over all events in the
sample
– Accumulate these average excess returns to arrive at
cumulative average returns (CARs)
6
 Lagged reactions to earnings 1- 7

announcements
Event study methodology (cont.)
– For each event, calculate standardized unexpected
earnings (SUE)
𝐸𝐸𝐸𝐸𝐸𝐸−𝐸𝐸(𝐸𝐸𝐸𝐸𝐸𝐸)
– 𝑆𝑆𝑆𝑆𝑆𝑆 = where EPS and E(EPS) are actual
𝑆𝑆𝑆𝑆𝑆𝑆
and forecasted earnings per share, respectively, and SEE:
S.E. of the estimate
– Based on these SUE values, each announcement
was put into one of the SUE categories
– CAR paths were calculated over the relevant quarter
for each of the SUE categories
7
 Lagged reactions to earnings 1- 8

announcements
Event study methodology (cont.): Results
– On the day of the announcement the market reacts
positively to positive surprises and negatively to
negative surprises
– Most notable is the tendency for there to be a
continued drift in prices, especially after
unexpected very good or unexpected very bad
earnings announcements
– This is inconsistent w/ market efficiency since it
appeared that the drift was sufficiently large

8
 1- 9

Small-firm effect
Small-firm effect
– Tendency for firms w/ low levels of market
capitalization to earn excess returns after accounting
for risk
– Using U.S. data, a portfolio(long the smallest firms
and short the largest firm) was able to earn 1.54%
per month during 1931-1975
– In addition, much of the effect was concentrated in
January, “January effect”

9
 1- 10

Small-firm effect
Explanations
– The tax-loss selling-pressure hypothesis: some
investors sold securities at the end of each calendar
year to establish short-term capital losses for income
tax purposes  the size of a stock’s rebound in Jan.
& poor performance in the prior year
– However, patterns in the data will often be found
merely because of randomness
The stability of the effect has been questioned
– The effect has declined dramatically in the last 20
years or so  publishes research has revealed to
arbitrageurs profitable opportunities
10
 1- 11

Value vs. Growth

Value vs. Growth
– Value stocks: stocks w/ prices that are low relative
to such accounting magnitudes as earnings, CFs,
and book value
– Growth stocks: stocks w/ prices that are high
relative to such accounting magnitudes
P/E ratios study (Basu, 1977)
– Sampling an average of 500 stocks per year over
1956-1969, he grouped them into quintiles on the
basis of P/E ratios

11
 1- 12

Value vs. Growth

P/E ratios study (Basu, 1977), cont.
– High P/E firms had lower returns than did low P/E
firms
– Market risk did not explain this regularity, however.
– Low P/E portfolios were actually less risky than
were high P/E portfolios
Book-to-market price (B/P) ratio study
– Firms w/ high B/P have tended to outperform firms
w/ low B/P
Is there consistency over different markets and
time periods? 12
Value vs. Growth portfolios: 1- 13

International evidence

13
 1- 14

Momentum and Reversal

Weak form efficiency
– Returns should not be predictable by conditioning
merely on lagged returns  This does not always
hold in practice
– The sign of the correlation is horizon-dependent
Momentum and reversal
– Momentum exists when returns are positively
correlated w/ past returns
– While reversal exists when returns are negatively
correlated w/ past returns

14
 1- 15

Momentum and Reversal

Momentum and reversal, cont.
– For short-term (one-month) intervals, there is reliable
reversal  primarily a technical issue
– For medium-term intervals (about 3-12 months),
there is well-documented momentum
– For long-term intervals (about 3-5 years) reversal is
typical
Reversal for LT intervals (De Bondt and Thaler,
1985): winner-loser effect
– Forming portfolios of the top/bottom 50 stocks in
terms of performance net of the market over the
previous three years  then track them going
forward 15
 1- 16

Momentum and Reversal

Reversal for LT intervals, cont.
– There are substantial differences: past lowers
substantially outperform past winners
– 1) Much of the difference is generated by the strong
performance of lowers rather than the weak
performance of winners
– 2) Much of the return boost/drop occurs in the month
of January
– 3) The difference is significant in a statistical sense,
but the p-values are not convincingly high

16
 1- 17

Reversal evidence

Source: Figure 3 from De Bondt, W. F. M., and R. Thaler, 1985, “Does the stock market overreact?” Journal of
Finance 40, 793–807. © 1985 Wiley Publishing, Inc. this material is used by permission of John Wiley & Sons, Inc.

17
 1- 18

Momentum and Reversal

Momentum for MT intervals
– A long-short zero-cost portfolio formed on the basis
of returns over the previous six months earned an
average excess return of 0.95% per month over the
next six months
– Momentum exists not just at the level of the firm, but
also at the level of the industry
– There is a relationship b/w post-earnings
announcement drift and momentum

18
 1- 19

Momentum evidence

19
Key trading rules that have shown to be 1- 20

effective i.

Small cap portfolios vs. large cap portfolios?

– Small cap wins out!
Portfolios formed based on P/Es:
– Low P/Es do better!
Earnings announcements momentum:
– Reaction to extreme announcements is slow!

20
 Key trading rules that have shown to be 1- 21

effective ii.
Value vs. growth portfolios (usually value firm
has a high book/market and a growth firm here
is one with an absence of value):
– Go for value!
Predictable serial correlation:
– Medium-term momentum!
Long-term winners vs. losers:
– Reversals: losers become winners!

21