EQUITY INVESTMENTS: EQUITY: MARKET ORGANIZATION,

MARKET INDICES, AND MARKET EFFICIENCY

MARKET EFFICIENCY
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READING 46 MARKET EFFICIENCY 2

 WHAT IS MARKET EFFICIENCY?

Informationally efficient capital market – one in which the current price of a

security fully, quickly and rationally reflects all available information about that
security.

 You can’t beat the market

Passive invesment – buying an index of securities.

Market prices should not be affected by the release of anticipated information.

READING 46 MARKET EFFICIENCY 3

 MARKET VALUE VS. INTRINSIC VALUE

Market value = current price.

Intrinsic or fundamental value = value that rational investor with full knowledge
would pay. Intrinsic value is constantly changing as new (unexpected) information
becomes available.

READING 46 MARKET EFFICIENCY 4

 WHAT MAKES MARKET MORE OR LESS EFFICIENT?

1. Number of market participants (larger – more efficient)

2. Availability of information (more info – more efficient)

3. Impediments to trading – transaction costs

4. Short-selling (improves efficiency)

5. Transactions and Information costs – markets will be inefficient if

costs of analysis and trading are greater than profit from trading
misvalued securities.

READING 46 MARKET EFFICIENCY 5

 VARIOUS FORMS OF MARKET EFFICIENCY

 Weak-form – current security prices fully reflect all currently available security
market data.

Investor can not achieve positive risk-adjusted returns by using technical analysis.

 Semi-strong-form – current security prices fully reflect all publicly available

information.

Investor can not achieve positive risk-adjusted returns by using fundamental

analysis.

 Strong-form – current security prices fully reflect all information from both
public and private sources.

Investor can not achieve positive risk-adjusted returns at all.

READING 46 MARKET EFFICIENCY 6

 IS IT POSSIBLE TO BEAT THE MARKET?

Abnormal profit – return greater than equlibrium expected return from the model

Technical Analysis – uses price and trading data (such as volume).

Fundamental Analysis – uses earnings, dividends, accounting ratios.

If markets are semi-strong efficient investors should invest passively (index

portfolio).
Most portfolio managers cannot outperform a passive index strategy over time.

BUT!
Portfolio manager can establish risk and return objectives, assist with
diversification, asset allocation, tax management.

READING 46 MARKET EFFICIENCY 7

 WELL-KNOWN MARKET ANOMALIES

Market Anomaly – something that rejects the hypothesis of market efficiency.

Data-mining bias – finding statistically significant relation without a common-sense
basis.

1) Calendar Anomalies – January effect and turn-of-the-year effect.

Possible causes: tax-loss selling and window dressing.
2) Momentum anomaly – high short-term returns are followed by continued high
returns.
3) Overreacting anomaly – firms with poor stock returns over previous 3-5 years
have better returns in subsequent years.
4) Size effect – small-cap stocks outperform large-cap stocks
5) Value effect – value stocks outperform growth stocks
6) Closed-end funds discounts
7) Earnings announcements – positive drift after earnings surprise
8) IPOs – are typically underpriced but long-term performance is below average.
READING 46 MARKET EFFICIENCY 8
 HOW CAN BEHAVIORAL FINANCE HELP?

Behavioral finance examines the actual decision-making process of investors.

Evidence that some investors exhibit bias or other deviations from perfect
rationality does not necessarily mean that market prices are irrational.

Typical biases:
 Loss aversion – investors dislike loss more than they like gain of the same
amount.

 Overconfidence – investors overestimate their ability to analyze information

 Herding – tendency to act on the same side of the market at once.

Information cascade – less-informed traders watch the actions of informed traders

and follow their actions.

READING 46 MARKET EFFICIENCY 9

 HOMEWORK ASSIGNMENT
READING
CFA® Level I Curriculum (2019) Volume V  Reading 46

PRACTICE PROBLEMS
CFA® Level I Curriculum (2019) Volume V  Reading 46  Practice Problems
MOODLE  CFA® Level I 2019  TESTS  Equity #3

READING 46 MARKET EFFICIENCY 10