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Lecture 3
The Efficient Market Hypothesis
Behavioral Finance and Technical
Analysis
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Prices as random walks
In 1953, Maurice Kendall examined weekly changes in
British industrial share prices. What he found surprised him:
“The series looks like a wandering one, almost as if once a
week the Demon of Chance drew a random number from a
symmetrical population of fixed dispersion and added it to
the current price to determine the next week's price.”
Prices looked like a random walk: a series of numbers
where each step is independent, identically distributed, with
zero mean.
This would imply that past performance is useless for
predicting price changes.
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Why unpredictable?
Suppose that price movements were predictable. Would we
expect that situation to last long?
A forecast about favorable future performance leads instead
to favorable current performance:
• market participants all try to get in on the action before the
price jump, which itself drives prices up.
So prices should move only in response to new information,
which is by definition unpredictable.
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Efficient Markets
Efficient market hypothesis (EMH)
• Prices of securities fully reflect available information.
• Investors buying securities in an efficient market should
expect to obtain a return that reflects risk (and time value
of money) given available information, but nothing beyond
that.
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Figure 11.1 Cumulative Abnormal Returns
Before Takeover Attempts
Figure 11.1 Cumulative abnormal returns before takeover attempts: target companies.
Source: This is an update of a figure that appeared in Keown, A., & Pinkerton, J. (19 81,
September). Merger announcements and insider trading activity. Journal of Finance, 36.
Updates courtesy of Jinghua Yan.
Access the text alternative for slide images.
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Competition as the Source of Efficiency
However,
You may say “What if I spend time researching and come up
with new information that wasn’t available before? Would
that be profitable?”
Yes. Grossman and Stiglitz (1980) show this in a model. In
equilibrium, producing new information will be profitable.
Otherwise, no one would ever produce any information.
Main point, though, is that to make returns beyond that
implied by risk, you have to have special information, and the
competition for producing that is intense.
This competition means that prices are very efficient: reflect
a lot of information, both easily available and obscure.
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Versions of the EMH
1. Weak-form asserts that stock prices already reflect all
information contained in the history of past prices.
2. Semi strong-form asserts that stock prices already
reflect all publicly available information.
3. Strong-form asserts that stock prices reflect all relevant
information, including insider information.
All versions assert that prices should reflect available
information, not perfect forecast. They should be correct
(reflect only risk compensation) on average.
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Technical vs Fundamental Analysis
Technical analysis—Identifies patterns in prices and volume
to predict returns.
• Weak-form EMH implies most technical analysis should
be fruitless.
Fundamental analysis—Uses public info (past earnings,
firm balance sheets, market and industry trends, quality of
management) to predict returns.
• Semi-strong form EMH implies most fundamental
analysis should be fruitless.
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Active Versus Passive Portfolio Management
Active Management Passive Management.
• Attempts to beat the • No attempt to outsmart
market by timing the the market.
market or through superior • Accept EMH.
security selection.
• Index Funds and E TF’s.
• An expensive strategy.
• Low-cost strategy.
• Suitable for very large
portfolios, as even a 1%
abnormal return can then
be a lot of money, which
justifies costs of active
management.
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Portfolio Management in an Efficient Market
If market is efficient, why not just throw darts at the Financial
Times? Is there any role for portfolio management?
Diversification: firm-specific risk can be eliminated through
diversification. Not just holding a lot of stocks, but making
sure their expectations and covariances are appropriate.
Risk profile of investor.
• If you work for Toyota, you probably don’t want to invest
much in auto stocks: not enough diversification.
• Age: If you are young and willing to hold stocks long term,
you can bear fluctuations in the market for a long-term
average higher return.
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Are Markets Efficient?
Magnitude Issue
• Only managers of large portfolios earn enough trading
profits to make exploiting minor mispricing worth the effort.
Selection Bias Issue.
• Only unsuccessful (or partially successful) investment
schemes are made public; good schemes remain private.
Lucky Event Issue
• For every big winner, there may be many big losers, but
we never hear of these managers.
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Weak-Form Tests
Returns over short horizons.
• Tendency of poorly performing stocks and well-performing
stocks in one period to continue that abnormal
performance in following periods is the momentum effect.
Returns over long horizons
• Reversal effect is the tendency of poorly performing
stocks and well-performing stocks in one period to
experience reversals in following periods.
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Figure 11.3 Prices Fluctuate Around Intrinsic
Value
Figure 11.3 Real (inflation-adjusted) value of S&P 500 and two estimates of intrinsic value obtained by
discounting future dividends plus terminal value in 2013 based on a constant-growth dividend discount
model. Discount rate equals 7.6%, the historical average real market return since 1871.
Source: Shiller, R. J. Speculative asset prices, revision of 2013 Nobel Prize Lecture, available at
www.nobelprize.org/uploads/2018/06/shiller-lecture.pdf.
Access the text alternative for slide images.
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Figure 11.4 Semi-Strong Tests: Small-Firm
Effect
Figure 11.4 Average annual return for 10 size-based portfolios, 1926–2021.
Source: Authors' calculations, using data obtained from Professor Ken French's data library at
http://mba.tuck .dartmouth.edu/pages/faculty/ken.french/data_Ilbrary.html.
Access the text alternative for slide images.
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Figure 11.6 Semi-Strong Tests: Post-
Earnings-Announcement Price Drift
Price Drift.
• Ball and Brown find a
sluggish response of stock
prices to firms’ earnings
announcements.
• Market appears to adjust to
the earnings information
only gradually, resulting in
a sustained period of
abnormal returns.
Figure 11.6 Cumulative abnormal returns in response to earnings announcements.
Source: Rendleman, R. J. Jr., Jones, C. P., & H. A. Latané, H. A. (19 82). Empirical anomalies based on unexpected
earnings and the importance of risk adjustments. Journal of Financial Economics, 10, 269–287.
Access the text alternative for slide images.
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Strong-Form Tests: Inside Information
The ability of insiders to trade profitability in their own stock
has been documented in studies by Jaffe, Seyhun, Givoly,
and Palmon.
• SEC requires all insiders to register their trading activity.
• Trades become public information.
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Interpreting the Anomalies
Feature that small firms, low market-to-book firms, and
recent “losers” seem to have in common is a stock price that
has fallen considerably in recent months/years.
• Fama and French argue that these effects can be
explained by risk premiums.
• Lakonishok, Shleifer, and Vishny argue that these effects
are evidence of inefficient markets.
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Interpreting the Evidence 1
Anomalies or data mining?
• Recall Harvey, Liu, Zhu paper in Lecture 2: testing too
many factors leads to spurious significance.
• Testing out of sample (new datasets around the world)
reveals that Book-to-market, size, and momentum are
probably real anomalies.
Anomalies over time.
• Should self-destruct in well-functioning markets, as
investors learn about them and trade on them.
• McClean and Pontiff find that anomalies do diminish after
they are published in academic papers.
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Mutual Fund Performance 1
Casual evidence does not support the claim that
professionally managed portfolios can consistently beat the
market.
In the last 50 years, a passive market index portfolio typically
outperformed the average equity fund.
But you might say that there are good managers and bad
managers and that good managers can consistently
outperform the market. Do such good managers exist?
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Table 11.1 Consistency of Investments
Results
Table 11.1
Consistency of investment results. Percentage of top-half funds that remain in the
top half in the following 2 years.
Percentage of 2019
Percentage of 2019
outperformers that
Number of top-half outperformers that
perform in top half of
performers in year perform in top half of
sample in both year
ending June 2019 sample in year ending
ending June 2020 and
June 2020
year ending June 2021
All domestic equity 1,041 71.8 19.0
funds
Large-cap equity funds 373 61.1 25.5
Small-cap equity funds 26.1 69.4 16.5
Source: Liu, B., & Sinha, G. (2021, October). U.S. persistence scorecard, mid-year 2021. S&P Dow
Jones Indices.
© McGraw Hill Source: Professor Richard Evans, University of Virginia, Darden School of Business. 20
Estimates of Individual Mutual Fund Alphas
Figure 11.8 Mutual fund alphas computed using a four-factor model of expected return, 19 93–2007. (The
best and worst 2.5% of observations are excluded from this distribution.)
Source: Professor Richard Evans, University of Virginia, Darden School of Business.
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Mutual Fund Performance 2
Consistency.
• Carhart – finds minor persistence in relative performance
across managers, but much of that persistence seems due
to expenses and transaction costs.
• Bollen and Busse – support for performance persistence
over short horizons (next graph).
• Berk and Green – skilled managers will attract new funds
until the costs of managing those extra funds drive alphas
down to zero. It’s also harder to find assets of the same
high alpha, as the low-hanging fruit has already been
picked. So alphas won’t be that persistent.
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Figure 11.9 Risk-Adjusted Performance in
Ranking Quarter and Following Quarter
Figure 11.8 Risk-adjusted performance in ranking quarter and following quarter.
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So, Are Markets Efficient?
Enough anomalies exist in the empirical evidence to justify
the search for underpriced securities that clearly takes place.
• However, the market is competitive enough that only
differentially superior information or insight will earn
money.
• Margin of superiority that any professional manager can
add is so slight that the statistician will not easily be able to
detect it.
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Overview: Behavioral Finance and
Technical Analysis
EMH makes two important predictions.
1. Security prices properly reflect whatever information is
available to investors.
2. Active traders will find it difficult to outperform passive
strategies such as holding market indexes.
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Behavioral Finance
Conventional Finance Behavioral Finance
• Prices are correct and • What if investors don’t
equal to intrinsic value. behave rationally?
• Resources are allocated • Arbitrageurs are limited
efficiently. and therefore insufficient
• Consistent with EMH. to force prices to match
intrinsic value.
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The Behavioral Critique
Two broad categories of irrationalities.
1. Information Processing: Investors do not always
process information correctly and therefore infer incorrect
probability distributions of future returns.
2. Behavioral Biases: Even when given a probability
distribution of returns, investors may make inconsistent or
suboptimal decisions.
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Information Processing 1
Limited attention, Underreaction, and Overreaction.
• E.g., focusing on recent high earnings, driving up P/E.
• Could also lead to low B/M, predicting low returns in future.
Overconfidence.
• Fidelity: men trade 2x more than women, and perform .4%
worse per year.
Conservatism.
• Investors are too slow in updating their beliefs in response
to new evidence, could lead to momentum.
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Behavioral Biases
Mental accounting
• Winning gamblers willing to take more risk, as they think of the bet
being made with their “winnings account,” rather than the hard-earned
money in their bank account.
• Can generate momentum, as well as size and B/M premium.
Regret avoidance
• Individuals who make decisions that turn out badly have more regret
when that decision was less conventional.
• Small firms are less conventional, need to offer higher return to
overcome regret avoidance.
Affect and feelings
• Fortune’s “most admired companies” (high affect), tend to have lower
risk-adjusted returns than least admired.
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Figure 12.1A Behavioral Biases: Prospect
Theory 1
Conventional view: Higher wealth provides higher utility, but
at a diminishing rate.
Access the text alternative for slide images.
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Figure 12.1B Behavioral Biases: Prospect
Theory 2
Behavioral view: Utility depends on changes in wealth from
current levels, not the level of wealth. It is convex to the left
of the origin → risk-seeking behavior in terms of losses.
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Limits to Arbitrage 1
Behavioral biases would not matter if rational arbitrageurs
could fully exploit the mistakes of behavioral investors.
Fundamental risk
• “Markets can remain irrational longer than you can remain
solvent” – Keynes.
• Intrinsic value and market value may take too long to
converge.
Implementation costs: transaction costs, short-selling
restrictions, no shares available to borrow, cost to borrow can
fluctuate.
Model risk: could have a bad model and market is correct.
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Figure 12.2 Limits to Arbitrage and the Law of
One Price 1
“Siamese Twin” Companies: Royal Dutch should sell for 1.5 times Shell.
• Deviated from parity ratio for extended periods.
• Example of fundamental risk.
Figure 12.2 Pricing of Royal Dutch relative to Shell (deviation from parity)
Source: Lamont, O. A., & Thaler, R. H. (2003, Fall). Anomalies: The law of one price in financial markets.
Journal of Economic Perspectives, 17, 191–202. Figure 1, p. 196.
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Technical Analysis and Behavioral Finance
Technical analysis attempts to exploit recurring and
predictable patterns in stock prices to generate superior
investment performance.
• Prices adjust gradually to a new equilibrium.
• Market values and intrinsic values converge slowly.
Behavioral biases may also be consistent with using volume
data
• Overconfidence can lead to excessive trade.
• So high volume can indicate overpriced stocks.
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Trends and Corrections
Momentum and moving averages
• How to identify trends? The moving average is the average
price over a given time interval, where the interval updates
as time passes.
• Bullish signal signifies a shift from a falling trend to a rising
trend.
• Bearish signal signifies a shift from a rising trend to a
falling trend.
• Either signal is identified by when the price crosses the
moving average.
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Figure 12.3 Share Price and 25-Day Moving
Average for Intel, February 1, 2022
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© McGraw Hill Source: Yahoo! Finance, January 7, 2019 (finance.yahoo.com). 36
Technical Analysis: A Warning
It is possible to perceive patterns that really don’t exist
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Figure 12.6: Actual and Simulated Levels
for Stock Market Prices of 52 Weeks
Figure 12.6 Actual and simulated levels for stock market prices of 52 weeks
Source: Roberts, H. (1959, March). Stock market “patterns” and financial analysis:
Methodological suggestions. Journal of Finance, 14, 1–10.
Access the text alternative for slide images.
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Figure 12.7 Actual and Simulated Changes
in Stock Prices for 52 Weeks
Figure 12.7 Actual and simulated changes in weekly stock prices for 52 weeks
Source: Roberts, H. (1959, March). Stock market “patterns” and financial analysis:
Methodological suggestions. Journal of Finance, 14, 1–10.
Access the text alternative for slide images.
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Technical Analysis: A Warning
It is possible to perceive patterns that really don’t exist
Figure 12.6A is based on the real data.
• The graph in panel B was generated using “returns”
created by a random-number generator.
Figure 12.7 shows obvious randomness in the weekly price
changes behind the two panels in Figure 12.6.
Most economists are wary of technical analysis: if you test
enough trading rules, some will work just due to chance.
Econ theory disciplines the test you conduct: gives you
reasons to trust the patterns and predict when they will no
longer hold.
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