Why I Like this Class….

• Two Brain Flips:

• Thinking about accounting

• From a compiler’s perspective (financial accounting classes) to a user’s perspective
• Creation vs. destruction/consumption

• Thinking about the complexity of the financial world

• Textbook accounting is like math.
• How do you generate forecasts of future performance?
• How far into the future do you need to go?
• Is risk quantifiable? If it is, how do you measure it?
• Given complexity, you have to be:
• Able to think
• Willing to ask questions
 The Efficient Markets
Hypothesis and Investor
Irrationality (Part I)
Malkiel, B.G. 2003. The efficient market hypothesis and its critics. Journal of
Economic Perspectives 17 (1): 59-82.
Shiller, R.J. 2003. From efficient markets theory to behavioral finance. Journal of
Economic Perspectives 17 (1): 83-104.
Caveats on the EMH Debate
• This is a complicated / complex subject
• Fair fight?
• Lots of strawmen thrown around by both sides
• Circular reasoning:
• If the market is highly efficient, what incentive is there to do the work that facilitates
efficiency (price discovery)?
How Do You Value A Firm?

Value = CF1/(1+r) + CF2/(1+r)2 + … + CFN/(1+r)N

What Causes Stock
Prices to Change?
WHAT IS THE INVESTOR’S
ULTIMATE GOAL?
The Investor’s Ultimate Goal…
• The goal is to earn excess risk adjusted rates of return.

• What does this mean?

• How is it measured?
• What are some problems associated with measuring it?
• Mike and the MRP
• How is it achieved?
Picking Stocks – Approach 1: Technical Analysis
• Technical Analysis: The use of trends in
historical market data (e.g., price and
volume) to forecast future price movements
• Investors who use technical analysis
believe that history often repeats itself,
and this repetition represents an
exploitable opportunity
• Psychological factors?

Head & Shoulders

Picking Stocks – Approach 2: Fundamental Analysis
• Fundamental Analysis (“Quantitative Analysis”): The process of using historical information
(e.g., financial statements, growth trends, economic conditions, competition levels, etc.) to
forecast future performance and use those forecasts of future performance to estimate
intrinsic (or real) value. That estimate is then compared to the current price and trading
decisions are made based on the comparison.

The Residual Income Valuation Model

Accruals vs. Cash Flows

Market Based Multiples Discounted Cash Flow Model

Price to Earnings (P/E) Value = CF1/(1+r) + CF2/(1+r)2 + … + CFN/(1+r)N
Price to Book (P/B)
Price to Sales (P/S)
MANY variants of these and MANY others
 THE BIG QUESTION
DO THESE STOCK PICKING
APPROACHES WORK?
If they do, what does this mean about the market?
The Efficient Market Hypothesis (EMH):
An Important Challenge to FSA and “Stock Picking” in General
• EMH – Markets process information efficiently, such that investors cannot earn returns that
exceed average market returns on a risk-adjusted basis
• Weak Form – Asset prices follow a random walk, so investors cannot predict future stock
prices based on historical public information about prices and returns
• Semi-Strong Form – Asset prices react (almost) immediately to new public information &
the reaction is not systematically biased (that is, there is no over- or under-reaction on
average)
• Strong Form – Asset prices react (almost) immediately to new public information & to
new private information
• Tangent – Insider Trading and Price Discovery

• Levels of Market Sophistication

• US Stock Market vs. OTC vs. Other (Land Mailers / Texts)?
Question:
• How many news events do you think occurred or will occur today that could have a material
impact on the price of WMT?

• WMT Chart
• WMT Annual Report
• WMT Edgar

• Tangent – Flash Boys / Run Edgar Run

 MALKIEL
Evidence of Inefficient Markets
Empirical Challenges to the EMH
Example 1: Short-Term Momentum
• Under the random-walk theory, the market has no memory
• Early academic research supported this contention
• Bad analogy: No such thing as hot hand in basketball or clutch hitter in baseball

• Recent work finds evidence of some short-term serial (time-series) correlations in stock
prices.
• This provides some support for the “rules” used by technical analysts
• Psych feedback loops
• Bandwagon effect
• Systematic under/over-reaction to news
Empirical Challenges to the EMH
Example 2: The January Effect

• Historical returns have been good in January, particularly among small capitalization stocks.
• Is the January effect exploitable?
Empirical Challenges to the EMH
Example 3: Predictable Patterns based on Valuation Parameters
• Can we predict future
stock price movements
based on initial dividend
yields or other valuation
metrics like price-to-
book (P/B) or price-to-
earnings (P/E)?
Empirical Challenges to the EMH
Example 4: Other Alleged Anomalies
• The size effect – Small firms outperform large stocks
• The value effect – Value stocks (low P/E or P/B) outperform growth stocks (high P/E or P/B)
 MALKIEL
Response to Evidence of
Inefficient Markets
Malkiel’s Explanations for Observed “Market Inefficiencies”
• Economic significance versus statistical significance
• Observed inefficiencies may not be exploitable after transaction and effort costs
• Market corrects – inefficiency goes away when publicized - see January effect on next slide
• Sampling issues – survivorship bias
• What part of the distribution do we pay attention to?
• What part of the distribution is more consequential?
• Black Swan – adverse tail events not in sample
• Implementation hurdles
• Transaction costs
• Liquidity
• Palm and 3COM
• BIG ONE – It is not an inefficiency, it is risk
• That is, the “excess returns” you believe you have captured (alpha) are not really excess returns –
they relate to a risk factor that you have not considered.

• Why do they fight so hard to defend the EMH?

• The models depend on it
• Circular reasoning – one of the explanations suggests the models are wrong
 MALKIEL
Evidence of Efficient Markets
Empirical Evidence in Support of the EMH
The Performance of Professional Money Managers
How Big is a 2% Difference in Performance?
• Scenario: Invest $10,000 at the beginning of year t.
• Option 1 – Invest with professional money manager at average 13% return
• Option 2 – Invest in S&P 500 Index fund at average 15% return

• Value at 5, 10, 15, 20, 25, and 30 years:

Value at end of year t +

Annual Initial
Option Option Type Return Investment 5 10 15 20 25 30

Option 1 Professional 13% 10,000 18,424 33,946 62,543 115,231 212,305 391,159

Option 2 Index 15% 10,000 20,114 40,456 81,371 163,665 329,190 662,118
But there
are some
really good
money
managers,
right?
A quote in support of the EMH
I have personally tried to invest money, my client’s money and my own, in every single anomaly
and predictive device that academics have dreamed up…I have attempted to exploit the so-
called year-end anomalies and a whole variety of strategies supposedly documented by
academic research. And I have yet to make a nickel on any of these supposed market
inefficiencies…a true market inefficiency ought to be an exploitable opportunity. If there’s
nothing investors can exploit in a systematic way, time in and time out, then it’s very hard to say
that information is not being properly incorporated into stock prices.
Source: Richard Roll, an academic financial economist and portfolio manager

IMPLICATIONS:
• For the Class
• For Decisions You’ll Have to Make
 The Efficient Markets
Hypothesis and Investor
Irrationality (Part II)
Malkiel, B.G. 2003. The efficient market hypothesis and its critics. Journal of
Economic Perspectives 17 (1): 59-82.
Shiller, R.J. 2003. From efficient markets theory to behavioral finance. Journal of
Economic Perspectives 17 (1): 83-104.
THE OTHER SIDE: EMH SKEPTICS
• Skeptics of the EMH argue that the stock market is competitive but not always efficient with
respect to public information
• Stock prices may deviate from fundamental value
• It is possible to earn excess risk adjusted rates of return if you can get good at estimating
fundamental value

• Why would the market be inefficient?

• Information-processing costs
• Transaction costs
• Short sale constraints
• Investor Irrationality
Short Sale Constraints
• Loss Aversion – Individuals tend to be more upset by losses than they are pleased by equivalent gains (Kahneman and
Tversky 1979)
• For long position – maximum loss = invested amount
• For short position – maximum loss > invested amount
• The supply of shortable shares is limited – Institutions typically lend shares, so if institutional ownership is low,
the supply of shortable shares is likely to be low
• Costs of shorting – Borrowers (shorter) pay a fee, like interest, to the lender of the shares. As expected, the fee
varies with the demand and supply of shares
• As the fee goes up, short positions become less attractive.
• Avg Fee for NYSE = 1.6% annualized; Avg Fee for NASDAQ = 3.74% annualized

Evidence of
Short Sale
Constraints
Why is the Market Inefficient? Investor Irrationality
• Feedback Models:
• Chain of Events:
• Step 1: Prices go up
• Step 2: The price increase creates some successes among investors
• Step 3: The price increase generates interest among other investors, media, etc.
• Step 4: Heightened attention leads to increased demand
• Step 5: Back to Step 1

• Feedback models are often supported with plausible “new theories” about how the world works,
e.g., the “new economy” talk around the dot-com bubble
• Ultimately, the high prices are not sustainable because they are not linked to fundamentals
(dividends, earnings, etc.) -> the bubble eventually bursts

• Biased Self-Attribution:
• Hirschleifer and Subramanyam (1999)
• When good things happen, people attribute the success to their own ability or intellect
• When bad things happen, people attribute the failure to bad luck or sabotage
Why is the Market Inefficient? Smart Money v Dumb Money
• Under the EMH:
• When an irrational pessimist sells, smart money buys
• When an irrational optimist buys, smart money sells
• Under this assumed setup, the effect of irrational traders is eliminated

• Is smart money always willing to play this role in the market?

• In some situations, they may choose to play the game along with the dumb money (they
just play quicker).
• In other situations, they may prefer to stay on the sidelines due to the risk inherent in
trying to correct prices in an irrational market

• Is smart money always able to play this role in the market?

• No – *see slide on short sale constraints
• 3COM and Palm example
EVIDENCE OF MARKET
INEFFICIENCY:
EXCESS VOLATILITY
Excess Volatility: Intuition
• In an efficient market, what should explain the volatility of market prices? That is, what
should cause price movements?
• What is the implication if these factors do not explain a significant portion of the volatility in
the stock market?
Excess Volatility: The Math
The basic efficient markets model can be written:
Pt = EtPt*
• Where:
• Pt = the price at time t
• Et = the mathematic expectation operator conditional on public information available at time t
• Pt* = the mathematical expectation, conditional on all public information available at time t, of the present value of
subsequent dividends accruing to that share
• The observed market price at time t (Pt) should be equal to expectations about the fundamental value (Pt*)
• The fundamental value (Pt*) is based on the market’s expectations about future dividends at time t, where expectations about
future dividends are based on all public information available at time t
• Therefore, all price changes should be caused by new information about the fundamental value (P t*)

If the EMH holds, then we can also write the following expression:
Pt* = Pt + Ut
• Where:
• Pt* = the mathematical expectation, conditional on all public information available at time t, of the present value of
subsequent dividends accruing to that share
• Pt = the price at time t
• Ut = the forecast error
• The fundamental value (Pt*) should be equal to the observed market price (Pt) +/- a forecast error (Ut)
Excess Volatility: The Math
• If the EMH holds, then we can also write the following expression:
• P t* = P t + U t

• Important inferences:
• The forecast error (Ut) must be uncorrelated with information available at time t because, if the
information was available, it should have been used in the estimate of fundamental value (P t*)
• The observed price (Pt) is information that is available at time t, so it must also be uncorrelated with
the forecast error (Ut)
• The variance of the sum of two uncorrelated variables equals the sum of the variances of the two
variables
• The variance of Pt* equals the sum of the variance of P t and Ut
• The variance of Ut cannot be negative (there is no such thing as a negative variance), so the
variance of Pt* must be larger than or equal to the variance of P t

• Punchline: under the EMH, where forecasts of fundamental value are assumed to be optimal (in that
they incorporate all available public information), the variance of the forecast (P t*) must be larger than (or
equal to if forecasts are perfect) the variance of the variable that is being forecasted (P t)
 Pt
Excess Volatility
Evidence
Pt*

Pt*

Conclusion: The forecast

series are significantly
less volatile than the
actual price series -> the
data are not consistent
with the efficient
Pt* markets model

Source: Shiller (2003)

 IMPLICATIONS:
• For the Class
• For Decisions You’ll Have to Make
Summary
• If you think the EMH Holds – US Stock Markets are Efficient
• Buy index funds
• Caveat: This reasoning is a bit circular – what if everyone does that (see next slide)
• Other markets may not be so efficient – small businesses, rental properties, etc.
• Solid understanding of drivers of value and why managers fixate on these drivers

• If you think the EMH does not hold – US Stock Markets are at Least Somewhat Inefficient
• All the above, plus…
• Fundamental analysis can yield excess returns
The rise of passive investing…

Source: Morningstar, Inc.