Market Efficiency and Behavioral Finance

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Efficient Market Hypothesis
(EMH)
Do security prices reflect information ?

Why look at market efficiency?

Implications for business and corporate

finance
Implications for investment

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Random Walk and the
EMH
Random Walk - stock prices are random

Actually submartingale

 Expected price is positive over time

 Positive trend and random about the trend

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 Security
Prices

Time

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Random Price Changes
Why are price changes random?
Prices react to information

Flow of information is random

Therefore, price changes are random

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EMH and Competition
Stock prices fully and accurately reflect
publicly available information.
Once information becomes available,
market participants analyze it.
Competition assures prices reflect
information.

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Forms of the EMH
 Weak

 Semi-strong

 Strong

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Types of Stock Analysis
Technical Analysis - using prices and volume
information to predict future prices.
Weak form efficiency & technical analysis

Fundamental Analysis - using economic and

accounting information to predict stock prices.
Semi strong form efficiency & fundamental
analysis

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Active or Passive
Management
Active Management
Security analysis
Timing

Passive Management
Buy and Hold
Index Funds

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Market Efficiency & Portfolio
Management
Even if the market is efficient a role exists for
portfolio management:
Appropriate risk level

Tax considerations

Other considerations

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Empirical Tests of Market
Efficiency
Event studies

Assessing performance of professional

managers
Testing some trading rule

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How Tests Are Structured
1. Examine prices and returns over time

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-t 0 +t

Announcement Date
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How Tests Are Structured
(cont’d)
2. Returns are adjusted to determine if they are
abnormal.
Market Model approach
a. Rt = at + btRmt + et
(Expected Return)
b. Excess Return =
(Actual - Expected)
et = Actual - (at + btRmt)

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How Tests Are Structured
(cont’d)
2. Returns are adjusted to determine if they are
abnormal.
Market Model approach
c. Cumulate the excess returns over
time:

-t 0 +t
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Issues in Examining the
Results
Magnitude Issue

Selection Bias Issue

Lucky Event Issue

Possible Model Misspecification

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What Does the Evidence
Show?
Technical Analysis
Short horizon
Long horizon

Fundamental Analysis

Anomalies Exist

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Anomalies
Small Firm Effect (January Effect)

Neglected Firm

Market to Book Ratios

Reversals

Post-Earnings Announcement Drift

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Explanations of
Anomalies
May be risk premiums

Behavioral Explanations
Information Processing Errors
Behavioral Biases
Limits to Arbitrage

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Information Processing
 Forecasting Errors

Overconfidence

Conservatism

Sample Neglect and Representativeness

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Behavioral Biases
Anchoring
Mental Accounting
Confirmation & Hindsight bias
Gambler’s fallacy
Hear behaviour
Over confidence
Overreaction and availability bias
Prospect theory

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Limits to Arbitrage
Fundamental Risk

Implementation Costs

Model Risk

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Mutual Fund Performance
Some evidence of persistent positive and
negative performance.

Potential measurement error for

benchmark returns.
Style changes
May be risk premiums

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