Financial Markets and Institutions

Lecture 6: Efficient Market Hypothesis and Behavioural Finance

Dr. Mary Dawood

Lecturer in Economics

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 Outline

Efficient Financial Markets

Forms of Market Efficiency

Anomalies of Market Efficiency

Behavioural Finance

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 Efficient Financial Markets1

1
Mishkin Chapter 7

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 Efficient Market Hypothesis

EMH was developed by Eugene Fama in 1965: financial markets

can direct funds to most valuable projects only if they are efficient

Financial markets are “informationally efficient” if security prices

fully reflect all available information about their fundamental value
(PV of expected future cash flows)

i.e. current prices reflect the collective beliefs of all investors in the
market about the future prospects of an asset

No one could consistently outperform the market by using

information that the market already knows except by mere chance

No trading strategy can beat the market ⇒ popularity of index

funds and “buy-and-hold” investments

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 Efficient Market Hypothesis

Arbitrage causes the full effects of new information to be reflected

“instantaneously” in actual prices

Thus current prices are adjusted before investors could trade on

new information and profit from them

Cycles self-destruct as soon as they are recognized by investors

⇒ stock price instantaneously jumps to fundamental value

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 Logic Behind EMH

Financial arbitrage: intense competition among investors to profit

from any new information

Identifying under-/overpriced stocks allows investors to buy/sell

some stocks for less/more than their “true” value

As more and more investors compete to detect “mispriced” stocks

(using forecasting and valuation techniques), likelihood of finding
unexploited profit opportunities becomes smaller and smaller

In equilibrium, no investment analyst will be able to profit from the

detection of mispriced securities except by chance

This arbitrage makes the market efficient and ensures that prices
reflect fundamental (true) values

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 Logic Behind EMH

Efficient markets are characterized by the following assumptions:

▶ large number of rational, profit-maximising investors

■ if some are naı̈ve or noise traders, their biases are random ⇒
cancel out, or are quickly corrected by rational arbitrageurs

▶ symmetric information that is freely available to all investors

▶ investors evaluate assets according to their intrinsic value

▶ security prices reflect their intrinsic value

Thus, when new information hits the market, security prices react
immediately and correctly (i.e. no under- or overreaction),
eliminating every opportunity for making abnormal profits

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 Random Walk Theory

Random walk theory follows from EMH, as the reaction of market

prices to new information is instantaneous

It states that successive stock price movements are random, i.e.

they have no pattern ⇒ the market has no memory

Thus, investors cannot earn abnormal profits by exploiting the

pattern in stock price movement

In the following scatter diagrams, each dot shows a pair of returns

of the same stock on two successive days

▶ no significant (serial) correlation ⇒ no pattern

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 Random Walk Theory

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 Random Walk Theory

This does not mean that stock price behaviour is simply arbitrary;
rather (like coin flip) each possible outcome has a fixed probability
of occurring that is totally independent of all previous outcomes

Thus, one can not predict the next outcome with any degree of
certainty, as each possible outcome is equally likely to occur next

Given information available today, the best estimate of future

stock price is today’s price (with a risk-adjusted time trend)

A mathematical representation of random walk is a martingale

process, where the conditional expectation of the next value in the
sequence is equal to the present value regardless of all prior values:
E [Xt+s |X1 , X2 , . . . , Xt ] = Xt for any t, s > 0

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 Random Walk Theory

Expected vs. actual future stock price

Abnormal return: difference between actual and expected return

ra = ri − E [ri ]
ra should fluctuate randomly around zero, i.e. occur only by
chance and on average cancel out

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 Empirical Evidence for EMH

Example 1: General Motors announced a major restructuring in

2001, closing 21 factories and cutting 74,000 jobs
▶ GM’s stock price fell by only 0.4% as the market had already
incorporated expectations about the restructuring into its price
▶ market reacted only to the difference between the anticipated
news and what was actually announced

Example 2: Before takeover announcement of Co-op Bank, there

was a small upward drift in its share price due to expectations
▶ after the announcement stock price changes were on average
close to zero
▶ full effect of the takeover attempt and its potential implications
was incorporated immediately

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 Six Lessons of Market Efficiency

Implications of EMH to financial managers:

1. Markets have no memory due to the random walk of asset prices

2. Trust market prices as they reflect all available information

3. Read the entrails because they impound all available information

4. There are no financial illusions because prices change only when

true value changes

5. No trading strategy can beat the market as arbitrage will

correct mispricing instantaneously

6. Do-it-yourself as there is no gain from paying others for what

you can do yourself

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 Forms of Market Efficiency2

2
Mishkin Chapter 7

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 Forms of EMH

EMH examines how much, how fast, and how accurately available
information is incorporated into asset prices so that it cannot be
used to foretell future price movements

Consequently, three versions of EMH can be distinguished

depending on the level of available information:

1. Weak Form: prices reflect all historical information

2. Semi-strong Form: prices reflect all publicly available

information

3. Strong Form: prices reflect all available information, public or

private (insider)

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 Weak Form Efficiency

prices reflect all information contained in past prices and returns

⇒ prices are not predictable using Technical Analysis: analysing

patterns in past price movements to predict future price changes

since past security prices are the most publicly and easily accessible
data, one should not be able to profit from using something that
“everybody else knows”

Statistical Tests:
▶ serial correlation tests: independence of prices over time
▶ cyclical behaviour tests in time series (Monday, January effect)
▶ tests of significance of gains from technical analysis

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 Weak Form Efficiency

Empirical Evidence
▶ Fama (1965) found that the serial correlation coefficients for a
sample of 30 Dow Jones stocks, even though statistically
significant, were too small to cover transaction costs of trading

▶ Subsequent studies have mostly found similar results across

other time periods and other countries

▶ Many studies found technical analysis to be either useless in

predicting changes in Dow Jones index, or that the gains from
conducting it are insufficient to cover transaction costs

▶ Random walk tests of stock prices around the world appear to

show very few systematic patterns in day-to-day returns

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 Semi-strong Form Efficiency

prices fully reflect all public information reported in financial

statements, firm announcement, macroeconomic factors, etc.

⇒ prices are not predictable using Fundamental Analysis: predicting

prices based on asset valuation techniques

stronger than weak form as it requires existence of market analysts

of the implications of vast financial info, which may be relatively
difficult to gather and costly to process

Statistical Tests: event studies that examine stock price changes

surrounding news; i.e. how rapidly they respond to new info
▶ if EMH holds, prices should jump all of a sudden and not move
before or after announcements

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 Strong Form Efficiency

prices fully reflect all information, even private and insider

⇒ even firm management will not be able to make gains from inside
information or company secrets other than by chance

Statistical Tests: very difficult as it requires testing the sustained

profitability of insider trading
▶ Security Exchange Commission in USA recently tracks insider
trading transactions by managers, directors, owners and major
stockholders using private information

empirical research in finance still has found no evidence that is

consistent with the strong form efficiency

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 Anomalies of Market Efficiency3

3
Brealey Chapter 13

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 Evidence against EMH

Returns on mutual funds vs. the market: mutual funds

outperform the market index in more than half the years

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 Evidence against EMH

Stock performance after earnings announcements:

▶ average return on stocks with the best earnings announcements
(portfolio 10) outperformed those with the worst earning news
(portfolio 1) by about 1% per month

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 Anomalies of Market Efficiency

In 1990s, empirical studies reported various departures from EMH

that cannot be explained by the traditional finance theory

Evidenced anomalies include:

1. Small-firm Effect: firms with low market capitalization tend to
earn abnormally high returns over large-cap stocks

2. Value Effect: firms with high book-to-market value tend to earn

abnormal returns relative to the market

3. Market Overreaction: stock prices may overreact to news

announcements and the pricing errors are corrected only slowly

4. New Information Delay: new information is not always

immediately incorporated into stock prices

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 Anomalies of Market Efficiency

Evidenced anomalies include: (cont.)

5. Calendar Patterns:
▶ January effect: investors tend to sell stocks that experienced
short-term losses before year end for tax purposes, and
repurchase them again in January ⇒ push prices up

▶ Monday effect: returns are significantly higher on Mondays

than on other days of the week

6. Short-term Momentum: recent past stock winners tend to

outperform recent past stock losers
▶ short-run positive serial correlation between successive
stock-price changes ⇒ reject random walk

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 Anomalies of Market Efficiency

Evidenced anomalies include: (cont.)

7. Long-term Mean-Reversion: stocks with low long-term past
returns tend to have higher future returns, and vice versa

8. Excessive Trading and Volatility: excessive trading volumes,

which cause prices to fluctuate much more than is warranted by
changes in news about fundamental value

▶ EMH suggests that investors will trade very little, knowing

they cannot beat the market ⇒ “buy-and-hold” strategy

Despite these predictable patterns, they are not dependable from

period to period, and are relatively small compared to transactions
costs involved in trying to exploit them

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 Behavioural Finance4

4
Brealey Chapter 13

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 Behavioural and Psychological Biases

Economists realised that stock prices are partially predictable and

that there are limits to arbitrage causing mispricing to persist
▶ information is costly to gather and analyse
▶ high transaction costs
▶ other trading restrictions

Behavioural economists also emphasized psychological elements of

stock-price determination and movements

Behavioural Finance tries to explain the observed market anomalies

by analysing investor’s psychological behaviour

It recognizes that investors are not strictly rational, but are subject
to some systematic cognitive biases that cause market inefficiency

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 Behavioural and Psychological Biases

1. Cognitive Dissonance: tendency to underweigh/overweigh news

that contradict/confirm prior beliefs ⇒ persistent mispricing

2. Familiarity Bias: preferring familiar stocks, thus assign less risk

to these regardless of their true risk ⇒ persistent mispricing

3. Heuristics: basing decisions on sentiments and intuitions rather

than on fundamentals and statistics ⇒ Monday/January effects

4. Representativeness: tendency to rely on past performance to

represent the future, thus buy recent winners and sell recent
losers ⇒ short-term momentum

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 Behavioural and Psychological Biases

5. Disposition Effect: seeking to feel good about own choices, thus

eagerness to sell winners and reluctance to sell losers
⇒ long-term mean reversion

6. Optimism Bias: tendency to believe that favourable outcomes

will occur, thus buying stocks that long lost favour and avoiding
stocks that had long-run ups ⇒ long-term mean reversion

7. Herding Bias: tendency to seek safety in numbers by following

financial trends and fashions ⇒ excessive trading

8. Downside Risk: people are not always risk averse, rather they
are risk averse towards gains and risk seekers towards losses
(take excessive risk when incurring large losses to recover them)
⇒ downside measure of risk instead of beta

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 Adaptive Market Hypothesis

AMH is developed Andrew Lo in 2004 to reconcile theories based

on EMH with behavioural finance

It argues that investors trade on heuristics, rather than strict

rational decisions, through a process of trial and error
▶ investors make initial decisions based on an educated guess of
what might be optimal
▶ they learn by the positive or negative outcomes of their
decisions and the changing market conditions
▶ they adjust their original choices to adapt to new information

Thus, profitable opportunities will arise from time to time as

investors learn and adapt with their various behavioural biases

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 Adaptive Market Hypothesis

AMH has several implications that contradict with EMH:

▶ Asset prices are somewhat predictable

▶ The relation between risk and return is not stable over time

▶ There are opportunities for profitable arbitrage

▶ Fundamental and technical analyses will perform well in certain

conditions

▶ It may pay to seek the expertise of financial analysts who have

less cognitive biases and better computational skills

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