Market Efficiency and

Anomalies

Chapter 5
Security Analysis
 What Is Market Efficiency?
 Informationally Efficient Market- efficiency with which information
is reflected in prices
» A fully efficient market will be such in which new information is
instantaneously reflected
» If only half of the information is reflected in the price instantaneously
and the other half sometime later then the market will said to be less
than fully efficient
» Markets that are less than fully efficient open an opportunity for
making profits because the inefficiency causes a mispricing in stocks

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 Can Capital Markets be Fully Efficient?
 Markets cannot be fully efficient because of the cost of
collecting and analyzing information, cost of trading and
limits on the capital available to arbitrageurs
 Limitation 1: Cost of information
» If markets are fully efficient then no investor has any incentive to generate or
report new information because the value of that information is zero
» Market participants must be compensated in some way for making the market
more efficient
» Thus instead of achieving instantaneous adjustment to new information, prices
can adjust to it only with a time lag
» This time lag allows market participants to earn a reasonable return on their
cost of obtaining and processing information

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 Can Capital Markets be Fully Efficient?
 Limitation 2: Cost of trading
» Traders incur costs while trading: their time, brokerage costs and other related
costs
» When the cost of trading is high, financial assets are likely to remain mispriced
for longer periods

 Limitation 3: Limits of arbitrage

» It is not clear when, if ever, the prices will return to equilibrium levels or when
the mispricing will disappear
» It is rare to find two assets with exactly the same risk
» Arbitrageurs have limited amount of capital which they devote to the most
profitable strategies
» Arbitrageurs act as agents and must abide by the restrictions imposed on them
by the owners of capital

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 What Is a Pricing Anomaly?

» A mispricing is any predictable deviation from a normal or expected return

» Deviations from the normal return are expected and must occur for risky
securities

 When is mispricing not a mispricing?

» Limitations and biases in the process of discovering mis-pricings are as follows:
 Data mining: Data-mining bias refers to an assumption of importance a trader assigns to an
occurrence in the market that was a result of chance or unforeseen events.
 Measurement of abnormal return: The abnormal return is calculated by subtracting the
expected return from the realized return and may be positive or negative.

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• Survivorship bias: is the logical error of concentrating on the people or things that made it past
some selection process and overlooking those that did not, typically because of their lack of
visibility. This can lead to some false conclusions in several different ways.
• Small sample bias: It consists of drawing false conclusions from statistical information, due to
having not considered the effects of sample size. Those wishing to reduce the risk of Sample Size
Neglect should remember that smaller sample sizes are associated with more volatile statistical
results, and vice-versa.
• Selection bias: Sample selection bias in a research study occurs when non-random data is selected
for statistical analysis. Due to a flaw in the sample selection process, a subset of the data is excluded
from the study, thereby impacting or negating the statistical significance of the test.
• Nonsynchronous trading: Non-synchronous trading results in a measurement error in the observed
data for returns on individual stocks, portfolios and market indices. 
• Misestimation of Risk is the uncertainty over current mortality rates. present in any portfolio with
demographic risk (not just mortality). • statistical uncertainty due to finite data. → Portfolios with
less data are more exposed to mis-estimation risk.

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 Why does a mispricing persist?
 Mispricing persist for a number of reasons, such as:
» The mispricing is not well understood
» Arbitrage is too costly
» Profit potential is insufficient
» Arbitrage is not possible due to trading restrictions
» Behavioral; bias may affect investment decisions