Efficient market hypothesis

MGT 521
Vivek Saxena
Asst. Prof. LSB
 What if ???
• Suppose investors had a model which could tell
them what stocks are on their way up
• They would reap in unending profits simply by
purchasing stocks that the model implied were
about to increase in price and then sell them
when the prices increased
• There is something inherently wrong with this
logic
• What would happen ?
• A model predicts with great confidence that a
stock currently at Rs.90 will rise in another 4 days
to Rs.100
• What would investors with access to the model do
today ?
• There would be a flurry of buy orders to cash in
on this prospective
• No one holding the stock would be willing to sell
• So price would start to go up
• And reach the target price of Rs.100 much earlier
• So the price will immediately reflects the good
news implicit in the model
• Forecast about favourable future performance
leads instead to favourable current performances
• Why ?
• Market participants try to cash in on the good
news – Price Jump
 Random Walk
• What does this mean ?
• New information by its very definition is
unpredictable
• If it was predictable it would have been a part
of today’s information
• Thus stock prices change in response to new
information, so they move unpredictably
• Random Walk
• But if it was as simple as that, why are there so
many analysts in the market looking for stocks
which are under priced, so that they can sell
them at a profit
• This means that markets are not following
random walk
• Which means that markets are not efficient
• And this has led to various versions of the EMH
 Random Walk
• Similarity between random numbers and stock
prices—Maurice Kendall 1953
• Liquid Particle movements and stock prices—
osborne’s brownion motion discovery
 What is an efficient market?
• Is the one in which the market price of the
security is an unbiased estimate of its intrinsic
value
• It does not mean market prices are always the
intrinsic values but the deviations or the errors
are random
 Versions of EMH
• Weak form hypothesis
• Semi strong form hypothesis
• Strong form hypothesis
 Weak form hypothesis
• Stock prices already reflect all information
that can be derived by examining market
trading data
• History of past prices
• Trading Volume
• What does this mean ?
• Technical Analysis is useless
• We don’t know anything about fundamental
analysis….
 Weak form hypothesis
• Past stock price data is publicly available and
virtually cost less to obtain
• All the information generated by technical
analysis has already been incorporated into
the price
• So a signal has lost its value
• Some of the best research firms in America
have been firing their technical analysts
 Semi strong form hypothesis
• All publicly available information is reflected in the stock price
• So technical analysis is useless
• And so is fundamental analysis
• Every body has access to publicly available information
• And they have already traded on it
• So the information has already been incorporated into the
price of the security
• There are many well informed and well financed firms
conducting such research and in face of such competition it
will be difficult to uncover data not also available to other
analysts
• But this does not happen all the time
 Strong Form Hypothesis
• Stock prices reflects all information relevant to
the firm even including information available
to the company insiders and private
information
• Not Possible
 Empirical Test for weak form
hypothesis
1.Correlations Tests
2.Runs tests
 Correlations Tests
• To check whether past price is influencing
present price
• Is the price change in one period correlated
with the price change in some other period?
• Studies conducted employing different stocks,
time periods and time lags
• No significant serial correlations or minor
positive correlations
 Correlations Tests
Prices Prices Change Change
650 2507 15 -45.5
665 2461.5 0 -97.75
665 2363.75 20 -60.5
685 2303.25 0 -223
685 2080.25 20 -120
705 1960.25 3.5 190.75
708.5 2151 -1.5 -70.75
707 2080.25 2.5 172
709.5 2252.25 -2.5 30.5
707 2282.75 -0.5 -227.75
706.5 2055 11.75 -23.5
718.25 2031.5 -3.25 197.5
715 2229 -5 -105
710 2124 -5 -60.5
705 2063.5 -7 -68.5
698 1995 -7 115.75
691 2110.75 14 167.25
705 2278 1.25 3
706.25 2281 2.75 -71
709 2210 6 82
715 2292 Correlation -0.00634
 Runs tests
• What is a run ?
• An uninterrupted sequence of one symbol
positive or negative
• ++++----++--+----+
Run test
1-Apr 881.5
2-Apr 856.5 -25
3-Apr 859.75 3.25
4-Apr 918.5 58.75
5-Apr 1010.25 91.75
8-Apr 1072.25 62
9-Apr 1074.5 2.25
10-Apr 1123.5 49
11-Apr 1203.5 80
12-Apr 1256.25 52.75
15-Apr 1341.5 85.25
16-Apr 1469.75 128.25
17-Apr 1450.25 -19.5
18-Apr 1306.5 -143.75
19-Apr 1258 -48.5
22-Apr 1332.75 74.75
23-Apr 1315.75 -17
24-Apr 1351 35.25
25-Apr 1407.5 56.5
26-Apr 1547.75 140.25
29-Apr 1521 -26.75
30-Apr 1484.25 -36.75
Run test
• No positive correlations between the change
in sign
• Supports random walk model strongly
 Test for semi strong form hypothesis

• Event study: Examines the excess returns

around a specific information event
• earning announcements, stock splits, bonus
issues, acquisitions and mergers, expansions,
govt budget, dividend announcement etc.
 Event Study-methodology
• Step 1 : Identify the event
• Pinpoint the announcement date
• Markets react to the announcement of an
event rather than the event itself
• Select a set of companies
Announcement Date
 Event Study
• Step 2: Collect returns data around the
announcement date
Announcement Date +n
-n
 Event Study
• Step 3: Calculate the abnormal return
• Abnormal return = Ri – E(Ri)
Where
• Ri = Actual returns
• E(Ri) = Expected returns
 Event Study: Interpretation
• Abnormal Returns are for a short period of
time= market is semi efficient
• Abnormal Returns are for a longer period of
time= market is not efficient
 Research-1
• Announcement effect of bonus issues on equity
prices : The Indian Experience
• Six year period from Jan 1 1995 to Dec 31, 2000
• Significant Abnormal returns for seven day
period before announcement was 10.1%
• No significant abnormal return on bonus day
• Overall the conclusion was that Indian stock
market is semi strong efficient
 Research-2
• How do Indian stock prices react to quarterly
earnings announcements
• Event study on BSE Sensex companies for the
quarter ended 30th June 2003 and the impact
they had on the stock price
• Indian markets are not semi strong efficient as
abnormal returns continued to occur even 30
days after the event date (almost till 45 days
after the announcement date)
 Strong form efficiency
• Not easy to test
• All investors who own more than a sufficient percentage of
outstanding shares or at sufficiently higher levels of the
organization are known as insiders
• Look at trading portfolios of such people when a particular
event happened. E.g. Reliance struck oil
• Look at analyst forecasts to check whether they have insider
info
• Insider trading
• Kenneth Lay: Enron Scandal
• Satyam Fiasco
Why investors lose money during a bull run

• What does the law of demand tell us ?

• Economic theory tells us that, ceteris paribus, higher
prices dampen demand and lower prices increase
demand
• What happens when the stock market is witnessing a
bull run ?
• As the stock prices go up, the more stocks appeal to
investors. This leads to investor psychology during a
bull run that is detrimental to the investor as well as
for the market
Why investors lose money during a bull run

• The herd mentality

• Like when you joined LPU, whose opinions
influenced you the most?
Why investors lose money during a bull run

• So if the world around you is going mad, you

must imitate them to some extent
• Like sheep in a herd, investors in a bull run
find it cozy to be inside the herd rather than
outside it
• Worldly wisdom teaches us that it’s better for
reputation to fail conventionally than succeed
unconventionally – John Maynard Keynes
Why investors lose money during a bull run

The Ant Effect

• Ants, when they get separated from their colony,
obey a simple rule: follow the ant in front
• Similarly, investor decisions are made in a sequence
• People, who invest in the stock market during a bull
run, assume that investing in the stock market is a
good bet simply because some of the people they
know have already done the same and made profits.
Why investors lose money during a bull run

• The Greater Fool theory

• There are only a given number of good stocks
in the market
• Riding the bull wave, stock prices of
fundamentally weak stocks also start to go up.
Driven by unrealistic expectations, these
unsustainable prices soon start to tumble and
the bubble eventually bursts
Why investors lose money during a bull run

• 'There is nothing so disturbing to one's well being

and judgment as to see a friend get rich.' - Charles
Kindleberger
• Greed
• Investors are human, after all. So, the lure of quick
wealth is difficult to resist. During a bull run, stock
markets offer astonishing returns in a short period of
time as compared to other investments. This helps in
attracting more money into the stock market
Why investors lose money during a bull run
• If we look at the present scenario in India interest rates on a six-
month fixed deposit with a bank stands at around 8 per cent per
annum.
• Other investment opportunities like the Public Provident Fund,
Kisan Vikas Patra, etc do offer better interest rates, but the
investment is locked up for a significant period of time.
• If one compares this with investment in an index fund (let us say
an index fund that mirrors the BSE Sensex), the one year return
on it would have been a whopping 80% (considering the period
from July 1, 2005 to June 30, 2006)
• Given this it becomes very difficult to stay away from the stock
market.
Why investors lose money during a bull run

Rear view mirror driving

• Investors in general, and especially during a bull run, tend to
look at the recent past pattern and assume that the future
patterns will be identical to the past ones
• This is as good as driving a car looking in to the rear view
mirror
• A rear view mirror-driven car will not meet with an accident
as long as the road ahead of the car is exactly as it is behind
the car.
• This is rarely the case, both on roads as well as in the stock
markets
Why investors lose money during a bull run

• But, when the stock market is on an upswing,

the more investors tend to believe that it will
keep going up forever.
• They mistake probability for certainty
• They pump in more money into the stock
market and this always does not go into the
right stocks.
Why investors lose money during a bull run

Mental accounting
• Richard Thaller, a pioneer of Behavioral Economics, coined the
term 'mental accounting‘
• Defined as 'the inclination to categorize and treat money
differently depending on where it comes from, where it is
kept and how it is spent’
• Cinema Example
• Research in Behavioral Economics shows that gamblers who
lose their winnings typically feel they haven't lost anything.
• The fact though remains that they would have been richer
had they stopped playing while they had won enough.
Why investors lose money during a bull run

• Investors during a bull run tend to behave similarly.

Once they have got a certain return on their investment
they tend to plough all their returns back into the
market
• There are only a given number of good stocks in the
market
• So money starts going into fundamentally weak stocks
• When such money goes into fundamentally weak stocks,
investment essentially boils down to speculation
Why investors lose money during a bull run

• Individual investors, while investing during a bull run,

ignore the most fundamental principle of investment
• Which is?
• High returns come with high risk
• And in the euphoria to make quick returns, investors
forget the risk involved in the stock market investments
• Individuals logically should seek information on where
to invest. But most investors do not. Few ask the right
questions at the right time and are naïve enough to go
with the crowd
Why investors lose money during a bull run

• An investor should have a good idea of the business

of the company he is investing in. Hopefully, this will
help him to make an informed decision
• Even as you read this, chances are that you may
think: 'This will not happen to me.' And this
false notion is at the root of all the problems. So,
ensure that your investments are based on strong
company and industry fundamentals and not just
hearsay
Thank you !!