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Learning outcomes. 
After watching this video, you will be able to, 
one, understand the meaning of market efficiency. 
>> Hello and welcome to this lecture on efficient markets and 
portfolio performance evaluation.
Play video starting at ::29 and follow transcript0:29
So, the first idea we want to explore is the idea of market efficiency. 
What is efficiency? 
Efficiency here refers very specifically to informational efficiency. 
What is informational efficiency? 
It simply means how quickly does information get into the price of any 
asset? 
It doesn't have to be a stock, a bond. 
It could be any asset, right? 
So the idea is the more efficient the market is, 
the quicker prices react to new information. 
And this is a really important concept because there is a great controversy out 
there in economic finance. 
Especially we'll see this disagreement between academics and 
practitioners as to whether the market is efficient or not. 
Before we get on with the business of efficiency, 
let me also remind you that efficiency does not mean that at all times, 
price is equal to what one might call intrinsic value. 
All they're asking is, if there are any pricing errors, 
they should not be systematic. 
In other words, a market will not systematically underprice or 
overprice any asset, right? 
So with that introduction, 
let me talk a little bit about whether a market can be perfectly efficient. 
So of course, when you start thinking about efficiency, 
let's say in engineering, about an engine, all right, 
it is usual to conceive of an engine which is 100% efficient. 
Now, does this 100% efficient engine actually exist in the real world? 
The answer is no. 
But then why do we need that benchmark? 
Precisely because we will benchmark every real world engine 
to this 100% theoretically efficient engine. 
Similarly, people started asking a long time ago, 
is it true that a market can or will be perfectly efficient? 
That is 100%. 
And the answer is not really and here is an argument by Grossman and Stiglitz. 
Way back 1980, they said the following.
Play video starting at :2:32 and follow transcript2:32
They said, look, no market can be perfectly informationaly efficient and 
the reason is, the story that they sketched out in their paper 
which I'm going to tell you in a few points. 
Number one, there is tons of investors in the market. 
Broadly we can classify them into two kinds. 
One is informed, one is uninformed. 
In other words, the informed investor trades based on whatever information they 
uncover regarding a certain security or asset. 
Why do uninformed investors trade? 
Not for entertainment certainly, they trade for, for example, liquidity reasons. 
That is to say, they want to, for example, I'm putting my daughter through college, 
so I want to liquidate part of my portfolio. 
Now that has nothing to do with any information I might have 
about a particular part of my portfolio, I simply want money right? 
So, at that point I'm acting as an uninformed investor. 
Now, focus on the informed investors for a little bit. 
Now these guys work really, really hard to find mispricings in the market.
Play video starting at :3:37 and follow transcript3:37
Obviously, if they find that something is priced lower than it should be, 
they would like to buy, and vice versa. 
Now, where do they get this information? 
Well, they acquire it, and then they process it, right? 
And acquiring information as well as processing information is inherently 
a costly process, why? 
Because we need smart brains, and smart brains don't come cheap, right? 
So that is the basic idea, 
that information is costly to acquire as well as process. 
Now these guys get this information, 
process it from usable certain securities and place trades. 
Now, the point of the matter is, the more informed traders there are and 
the harder they work, the more difficult it is to find inefficiencies. 
So imagine there's a bunch of 500-rupee notes lying on the floor, right? 
Now, of course, this situation won't last very long because some of us 
smart people will quickly pick up the 500 rupee notes, and walk away. 
Now, the fact is, the more number of people there are searching for 500 
rupee notes, the fewer 500 rupee notes you are likely to find lying on the ground. 
That is the idea here. 
So the very act of trying to utilize information 
to trade drives prices closer to value and 
that is really the idea of these informed traders making the market efficient. 
However let's say they make the market so efficient that it is 100% efficient. 
That is price equals value perfectly. 
What happens then? 
Then, the informed traders basically see there is no return to debt acquisition and 
processing information because they have no advantage over anybody 
else in the market. 
So at that point what happens, well, they move on to other places. 
And they say, I am going to look for the inefficiency there or here. 
But, then the moment these guys walk out the door and go to some other market, 
what happens is, now this market itself paradoxically becomes again 
a little inefficient and then more inefficient, right? 
So, now the point to note here is, what is going to happen now? 
Again people are going to enter this market in the hope of making money. 
So this is a vicious cycle right? 
It is a state of disequilibrium which can only be broken in one way, right? 
Mathematically and logically, right? 
And the way to break this cycle is to think of a market as being 
efficient only to the extent that the marginal trader recoups his or her cost.
Play video starting at :6:18 and follow transcript6:18
So that is really the idea of Grossman and Stiglitz. 
Now of course, this is an old argument, but 
I want really pick on a couple of implications of their argument. 
Number one, since there's lots and lots of investors who are looking for 
inefficiencies and this we can see all around us. 
There's lots and lots of market participants. 
They're all there to make money. 
So you can be sure that there are many, many investors looking for 
these mis-pricings or inefficiencies. 
Which means that finding the probability of finding easy 
money opportunities is probably not going to be there. 
Which simply means that markets will be largely efficient, to a large degree, 
is what we're saying. 
Number two if there is a certain market 
where the cost of exploiting efficiency is higher. 
For example information acquisition costs are higher or 
maybe smart MBA students are in short supply.
Play video starting at :7:16 and follow transcript7:16
In these cases when cost of finding these pricing is actually going to go up. 
Well, naturally you are more likely to find inefficiency 
synthesisely those market. 
In other words, what we are saying is not that nobody can make money. 
If you are better than me marginally at acquiring slash processing information. 
You can make a little more money than I can. 
So you, if you're the marginal investor, 
you will make money to the extent that you recoup your costs, that's the idea here. 
Finally, the degree of inefficiency in any market. 
And when I say market, 
I don't mean geography, I mean any asset market will depend upon the number of 
informed investors who are around who are closely looking to exploit opportunities. 
So that's really the story of Grossman and Stiglitz.

V2
Learning outcomes. 
After watching this video, 
you will be able to, one, 
list down the various versions of efficient market hypothesis, two, 
understand the issues in testing the efficient market hypothesis. 
Now, efficient markets hypothesis is basically a thesis or 
a theory that has been formulated a long time ago in 
the 1960s I should say, in three forms. 
That is, there are three flavors of this theory. 
Like coffee, this theory comes in three flavors decaf, 
half caff, full caff. 
Weak form efficiency basically says, look, 
you cannot use a series of 
past stock prices to predict future stock prices or any asset price, 
but I'm going to take the example of stock. 
If you take any stock, your favorite stock, 
and if you look at a chart of previous prices, 
let's say for the last three months, three years, 
10 years and so on, 
that old pattern of prices that has been followed up to 
now simply cannot be used to predict stock prices tomorrow. 
What that simply means is, technical analysis, 
that is the study of stock charts and trying to figure 
out future prices is completely useless. 
Number two, the second form of this is semi-strong. 
This is not only past prices, 
but no publicly available information can be used to make extra profits. 
Which is saying, basically if I look at the annual report of a company which was just 
released yesterday and I think I can analyze it very well, 
and I can make money off of my analysis, 
I would be wrong according to the semi-strong form of efficiency because 
all publicly available information as soon as it 
is disseminated is going to get into the stock price. 
In other words, all those analysts who are working on Wall Street, 
who are doing what is known as fundamental analysis, 
that is to say, analyzing publicly listed companies in the hope 
of trying to find investment opportunities are simply wasting their time. 
At least that's the implication of this form of the fuel. 
The strongest form of efficiency which is 
really really tough to believe actually is that, 
no information public or even private, 
notice that the strength of efficiency is going up as we move from form one, 
to form two, to form three. 
The most extreme form of this theory, 
the strong form, no information at all can be utilized to make extra profits. 
For example, the CEO of a well-known publicly listed company, 
even if he were not prevented by 
law from trading in the stock of his company could not make 
any extra profits over and above the average man on the street 
simply because he has information which is in his mind, 
is already inside the stock place. 
It's little tough to believe, 
I know, but that's the theory. 
Now, if this is the theory, how do we test it? 
See naturally, especially students who are engineers or scientists etc, 
whenever I posit a theory will usually ask me the question, how do we test this Ramana? 
Because in the sciences we have certain laws 
which we posit and we find ways and means of testing those theories. 
For example, if you say at 
a fixed temperature the relationship between the pressure and volume 
of the gas is in a certain direction and 
that's something known as Boyle's law in physics. 
How do we test that? Well, you naturally think of setting up a laboratory experiment 
where you hold temperature constant and you vary 
the pressure on a certain gas or the volume, 
and observe their effect on the other factor. 
That's very easy to do in a science a setting. 
Now in economics and finance, 
unfortunately these natural experiments are terribly difficult to set up. 
So naturally we have to depend on past data regarding 
financial markets to try and tease out whether the market is efficient or not. 
Now, there are several issues in testing the so-called efficient market hypothesis. 
It is not a trivial job. 
Issue number one is magnitude. 
How efficient is the market? 
Can we observe the magnitude? What do I mean by that? 
Let's say there is a mutual fund manager who can beat the market by 0.5% per year. 
Now, that is really valuable to his clientele because he's 
making half a percent more than everybody else in the market on a consistent basis. 
The question is, since half of percent is very small compared to 
the variation in stock returns let's say on an annual basis, 
can we really observe this 0.5%? 
Unlikely. Because statistically all your estimates 
of out-performance are going to be reading with 
error and this error is going to be directly 
proportional to the availability of the stock return itself, 
so obviously it's very tough to tease out that 0.5% extra performance. 
Number two, there is something called a selection bias. 
In other words, if you go out and take a poll of people, 
that is investors, and try and see if they're making money. 
Now, if you really had a money machine at your home, 
that is you had a winning formula, 
the question is, would you publicize that fact? 
Maybe if we are observing only those people who cannot beat the market and 
the people who are actually beating the market handsomely are hidden out of plain sight. 
Of course, some of them are not hidden in plain sight. 
We have the Warren Buffett of the world who are consistently beating the market on 
a fairly hefty basis and they are out there in plain sight so that's the question. 
That leads me to point number three. 
Suppose there are these fund managers who really beat the market consistently, 
are they skilled or are they lucky? 
This is an age old debate again. 
How do you separate skill from luck? 
This famous story is often told by efficient marketeer is that, 
if you give, say, 
32 monkeys fair coins and ask them to flip coins and 16 of them on average, 
we know, will flip heads. 
Now we declare the guys who flipped heads the winners and take them to round two. 
In round two, 16 monkeys will flip coins again and so on until at the end of five rounds, 
what you're going to end up with is one monkey that flipped five coins, 
five heads rather in a row. 
The question is, is this monkey particularly 
skilled at flipping coins and making them come up heads, 
or did the monkey just get lucky? 
Now, the story is usually told with monkeys 
because if you tell the story about human beings, 
we have these biases, 
maybe we can train a person to flip heads all the time. 
But the point is, you really cannot reasonably conceive 
of a way of teaching a monkey flipping heads. 
So that's the origin of that story. 
But the point really is, 
are people just lucky if they have this run of winning stock returns to 
a fine performance or are they just supremely skilled? This is a debate. 
Now, of course if somebody has beaten the market over 50 years, 
let's say like on average Warren Buffett has been doing very well for many many decades. 
It is really tough to dismiss his performance as coming from something being pure luck. 
On the other hand, you have to ask yourself the question, 
everybody has been observing Mr. Buffett's performance over the past several decades, 
several books have been written about his investment style, and famously, 
he himself has described his investment style in very simple language year after year, 
month after month for the past several decade. 
But the question arises, 
if I simply read everything Warren Buffett has said and 
done and follow the same strategies, 
can I make money? 
The answer is, not really because this is one special individual. 
If it was so easy to discover Buffett money machine and all of us make money, 
well, life would be much simpler. 
Unfortunately, we live in a more complex world. 
The next issue in testing efficiency is, 
fine, somebody has indeed beaten the market, 
then the natural response of a finance theorist like myself would be to say, "Well, 
I'm not surprised you made more money than the market 
because you took a greater risk than the risk of the market." 
And then you'll ask me, "Well, 
how do you figure out whether 
my extra return is commensurate with the extra risk I'm taking?" 
Well, immediately you need a model that really links risk and return, 
and those models are called asset pricing models. 
The CAPM, the capital asset pricing model being one of the more famous examples. 
Now the question is, how do you come up with the right risk adjustment? 
We can always fight about the model. 
In other words, it could be that the market is really efficient, in other words, 
you really did not make extra compensating for the risk but if I use the wrong model, 
it will show up that you had better or worse performance relative to the model. 
Or the model itself may be a perfect model 
describing the commensurate risk for the commensurate return. 
However, the market may be inefficient. 
How do we separate these two hypotheses? 
Is practically impossible. So the idea is, 
there's lots of tests that have come up and people have nevertheless tried to do this.

V3
After watching this video, 
you will be able to, one, define an anomaly. 
Two list down various market anomalies. 
>> So is emergent at this point clearly after many, many, 
years of research that, there are several what are known as anomalies. 
What are anomalies? 
Anomalies have something those are exceptions to the norm. 
For example, there is a well known size effect. 
What is a size effect? 
It simply says that, portfolios of small cap stocks, 
that is, smaller company stocks. 
And abnormally higher returns than large company stocks, even after. 
And this is important. 
Even after you control for beta risk, 
beta is the cap time data here I'm talking about. 
All right, and the graph, which we're showing you, is basically going to exactly 
illustrate the fact that small stocks beat large stocks even after accounting for 
what we traditionally called risk which is beta, right? 
That's one anomaly, the second anomaly, which is very striking, 
is the value versus growth anomaly, here the idea is very simple. 
Suppose we sort all stocks in the universe, 
when I say universe all the stocks in a particular exchange let's say. 
And we sort them by the so called Book to Market ratio. 
That's simply the book value of equity on the balance sheet, 
divided by the market value of the equity. 
Which is basically the market price times the number of shares in the market, right. 
So you take the book value to the market value, 
just think a bit about what this ratio means, 
if the book to market ratio is high, in word that the market to book ratio is low. 
Which is to say for every dollar of book value the market is 
placing a lower market value on your company right? 
Typically for growth companies where the book value is likely to be very small, 
take a high tech company for example, 
the market value is likely to be several times higher than the book value. 
Which is to say these growth stocks typically have 
very low Book-to-Market ratios. 
And value stocks typically have high Book-to-Market ratios. 
So somebody did this very simple experiment of sorting every year, 
stocks in two value category and growth category. 
Basically taking the high book to market stocks calling them value. 
Take the low book to market stocks, call them growth and basically let serve 
it on a horse race between two portfolios of value and growth. 
We start each of them with $100 or rupees or any currency, right? 
And let them perform and 
observe their performance after the portfolio has been formed. 
And you keep doing this, not for one year, but for let us say in this figure of 
you're seeing, 22 years of data on US value US growth. 
And what do you see? 
You see that 100 rupees or 100 dollars in 1973 would 
have ended up at about $600 in growth, but 
more than triple that, about $2200 in value. 
Now what does that tell you? 
It tells you that value outperforms growth handsomely, 
at this point this is not evidence of inefficiency. 
This is simply saying that look, 
historically values stocks have performed better than growth stocks. 
Now, a natural response as l said before is to say 
well if value outperform growth in terms of returns, 
it must be that value stocks are somehow riskier than growth stocks. 
Now people have tried to measure whether value and 
growth stocks are different betas and there is no. 
In this diagram for example I'm showing you that in fact if you look at volatility 
or the sigma or the standard deviation of the returns of value versus growth. 
What you're going to see is that growth is almost certainly almost always, 
the higher volatility portfolio compared to value. 
This is bizarre for a finance 
basically this is telling you that you've picked a bunch of stocks 
which are low risk simply based on the label high book to market. 
And you can earn more then, the opposite strategy of picking growth stocks. 
Now that can be construed as an evidence or 
a piece of evidence against efficient market. 
Now the other anomaly I wanted to talk about briefly is the idea called momentum. 
The basic idea of momentum here is suppose at the beginning of this year 
on January 1st I sort all stocks based on the past six months returns. 
Easily done, we could easily do it on a computer, very quickly, 
and let us say the top decile that is the top 10% of these stocks we start 
calling them winners and the bottom 10%, we start calling them losers. 
Just labels. 
Winners that essentially those who have performed well in the recent past, and 
losers, those who have not performed well at all in the last six months. 
So what I say I'm going to perform this portfolio of buying 
these winners and selling the losers, right? 
Now if the market were efficient, 
what would we expect the result of this net portfolio over the next month, 
three months, six months and one year, the answer is zero. 
Because all we have done is we have sorted stocks based on their past returns. 
And if markets are deficient, past returns should not help us to predict or 
make trading strategies, which are going to inform us about future returns. 
But if you look at the graph, what you find is, 
the winners continue to outperform, over the next six months or so. 
And the losers continue to underperform, over the next six months. 
In other words the winner minus loser portfolio makes about 1%. 
And this is not trivial number because this is 1% per month. 
So 1% per month for free essentially. 
So that's a 12% if you include compounding etc. 
Now nothing in the nature of efficient market 
seems to be able to explain this phenomenon. 
So, I've talked about size, 
I've talked about book to market, I've talked about momentum, all right. 
So, all of these point to one direction which is that
Play video starting at :6:55 and follow transcript
the markets are probably not as efficient as we would like them to be, 
at least we meaning, academics would like them to be. 
But this also points to the fact that there is money making opportunities out 
there and the smarter and more intelligent investors. 
As I said before somebody was able to acquire, and more importantly, 
process because in today's world with technology 
etc acquiring information is not the key element. 
Information is everywhere, in fact we have too much of it, but 
then processing this information in an intelligent way.
Play video starting at :7:30 and follow transcript
If I can do it better than you. 
I stand a chance of making money. 
So essentially what we're claiming is people like Mr. 
Buffett really get the same information as you and I. 
Except they are able to process it better, they are able to put it to better use and 
they are able to invest smarter than people like you and me