Equity Investments

Reading 35 – Market Efficiency

The Concept of Market Efficiency (1/4)
The Description of Efficient Markets
● Efficient Market → Prices reflect all past and present information, quickly and
rationally.

● The level of efficiency determines the lack or existence of trading opportunities →

Market inefficiencies.

Highly
Passive Active Inefficient
Efficient
Markets Investment Investment Markets
The Concept of Market Efficiency (2/4)
The Description of Efficient Markets

Prices reflected Prices reacts to non-

“quickly” anticipated events
-Time to execute the -Investors process
trade to exploit information and revise
inefficiencies. expectations accordingly.
- Time of asset price to
incorporate information.
The Concept of Market Efficiency (3/4)
Market Value vs Intrinsic Value

VS

Market Value Intrinsic Value

Market Efficiency Market Value = Intrinsic Value

Market Efficiency Market Value <> Intrinsic Value

The Concept of Market Efficiency (4/4)
Market Value vs Intrinsic Value

Factors Contributing to and Impeding a Market’s Efficiency

• Number of market participants → (+) Market Efficiency.

Market
• Securities not followed by analyst incorporate mispricing.
Participants
• Lack of trading may cause/accentuate other market imperfections.
• Companies listed in NYSE, LSE, TSE have high disclosure requirements → Quite
Information and efficient.
Financial • Lack of trading activity and information availability in small, emerging markets → Less
Disclosure efficient.
• In OTC markets Dealers define the degree of efficiency.
• Arbitrage contributes to market efficiency.
Limits to • Arbitrage is not possible in markets with operating inefficiencies (difficulties in trade
Trading execution, high trading costs, lack of transparency).
• Short selling restrictions impede market efficiency.
Forms of Market Efficiency (1/2)

• Private information
Strong form • Fundamental analysis
• Technical analysis
• Private information
Semi-strong form • Fundamental analysis
• Technical analysis
• Private information
Weak form • Fundamental analysis
• Technical analysis
Forms of Market Efficiency (2/2)
Implications of the Efficient Market Hypothesis
● Fundamental Analysis
○ Involves the estimation of an asset’s value using company data. Decision of buy/sell
depends on whether market price is different than estimated intrinsic value.
○ Fundamental analysis facilitates a semi-strong efficient market.

● Technical Analysis
○ Attempts to profit by looking at patterns of prices and trading volume. Costly to exploit;
does not produce abnormal returns.
○ Arbitraged away quickly. No abnormal returns attainable.

● Portfolio Management
○ If markets are weak and semi-strong efficient → Passive portfolio management should
outperform active portfolio management.
○ Role of Portfolio Management: Manage a portfolio consistent with objectives, risk
preference, asset allocation, etc. (not to beat market)
Market Pricing Anomalies (1/2)

● Market anomaly: Change in prices not linked to current relevant information or new
information into the market.

● Valid if it is consistent over reasonably long periods.

● At first glance anomalies produce excess returns but exploiting it may become
unprofitable when risk and trading costs are considered.
Market Pricing Anomalies (2/2)

• January effect: Returns in January significantly higher compared with other months.
More pronounced in small-caps.
Time-Series • Turn-of-the-month effect, Day-of-the-week effect, Weekend effect, Holiday effect.
Anomalies • Overreaction effect: Investors overreact to the release of unexpected public information.
• Momentum: Securities that have experienced high returns in the short term tend to
continue to generate higher returns in subsequent periods.

• Size effect: Equity of small-cap companies tend to outperform equity of large-cap

Cross-Sectional superar
companies on a risk-adjusted basis.
Anomalies • Value effect: Value stocks outperformed growth stocks over long period of time.

• Closed-End investment fund discounts.

• Earning Surprise: Reflected quickly in stock prices but the adjustment process is not
always efficient. Finding is that investors can earn abnormal returns by buying (selling)
Other Anomalies
stocks of companies with positive (negative) earning surprises.
• Initial Public Offerings (IPO).
• Predictability of Returns Based on Prior Information.
Behavioral Finance (1/5)

● Examines how investor behavior affect what is observed in the financial markets.

● Asset-pricing models and EMH assume that markets are rationality, so it gives some
space for individuals to be “irrational”.
Behavioral Finance (2/5)

Behavioral Biases

• Risk-averse investor: Dislike for risk but willing to assume if it is adequately compensated
with higher returns.
Loss Aversion
• Behavioral point of view: Dislike for risk is not symmetrical (overreact over losses vs
comparable gains).
• Investor place too much emphasis on their ability to process and interpret information
about a security.
Overconfidence
• May cause mispricing (temporary and corrected eventually).
• Most seen in higher growth companies.

• Representativeness. • Disposition effect.

Other Behavioral • Gambler’s fallacy. • Narrow framing.
Biases • Mental accounting. • Confirmation bias.
• Conservatism.
Behavioral Finance (3/5)

Loss Aversion Overconfidence

Behavioral Finance (4/5)

Confirmation Bias Narrow framing

Behavioral Finance (5/5)

● Individual biases can lead to herding behavior or information cascades.

● Herding: Clustered trading (may or may not be based on information).

● Information cascades: Participants who act first influence the decision of others
(may be rational or irrational).

Herding Information Cascade

Rational
informed
investor

information
Rational
cascade
Equity Investments
Reading 35 – Market Efficiency