Topic 6: Market Efficiency and Behavioral Finance
Review of Previous Topics
- Previous chapters: Determining or modelling expected rates of return
o Average of historical returns
o Scenario analysis
o Index models
o Equilibrium models (CAPM)
§ Different from other models, because it is a theoretical model that states that expected return is
a function of risk
§ Explains how expected return is linked to risk
o Valuation models (Next Part)
- Equilibrium models (CAPM) imply that you get “value for money”: expected return as compensation for risk
o Other methods not necessarily
Market Efficiency
Efficient market
- Price you pay for an asset equals the fair value à Pt = Vt
o Implication: Y = 0 à E(r) = k = rf + Z[E(rm) + rf]
- Investors behave rationally
Inefficient market
- Pt ≠ Vt
- Examples: IT bubble, price of IT stocks was much higher than fair value of those companies
o Everyone bought IT stocks, resulting in increasing prices
- Investors do not act in a rational way
- Implication: Y ≠ 0
o Y < 0 à stocks are overpriced (cf. IT stocks)
o Y > 0 à stocks are underpriced, interesting investment opportunity
Active versus passive management
Assumption: equilibrium models (CAPM) hold
- Result: optimal risky portfolio = market portfolio, all investors invest in this market portfolio, there should thus
be only 1 fund that has the market portfolio, and active management is not useful
- Passive management is appropriate
o CAPM: all Y = 0 à all stocks are correctly priced à by investing in individual assets, it’s not possible to
make an additional profit
- Investment strategy: market index fund (no analysis needed)
Active management: Can you do better?
- Asset allocation: optimal portfolio selection based on asset classes
o Use method to determine input parameters
- Security selection: optimal portfolio selection based on individual assets
o Use valuation methods
- Yp = Y of the portfolio = weighted average of Y’s of individual assets
Better than what?
- Active management should lead to higher returns (abnormal returns)
o Actual return > return as compensation for market risk (positive ex-post Y)
o Return higher than benchmark return (mostly the market)
- How outperform the market?
o Your information must be better than the market
100
, o You should have access to information that isn’t available in the market
o P: Value of stock reflected by the market
§ Price that all investors in the market believe is the correct price
§ Decided by demand and supply
o V: Value of the stock based on your own information
o P = V à You would expect that your information is already reflected in the market
o Suppose at time t: Pt = 100 and Vt = 110 à P ≠ V (not possible in an efficient market)
§ Perhaps you know that the company will do a profitable investment, and only you and the CEO
have access to this information à inefficient market
§ Y = +10%
- If you can’t outperform the market, it doesn’t make sense to manage actively
What is reflected by the market?
- Market efficiency concepts
Efficient Capital Markets
- In an efficient capital market:
o Security prices adjust rapidly to the arrival of new information
o Current prices reflect all information about the security
o Implication: Stock prices should follow a random walk
§ Stock price changes are random and unpredictable
§ Random walk: Pt = Pt-1 + et where ei reflects new information
• New information is random
• In efficient markets, this new information is reflected in the price immediately
§ Reason: At the time that there is new information, everyone (rational investors) will start
buying/selling and the price adjusts immediately, thus by the time you want to buy/sell, the
price is already adjusted
o Result: price changes are not predictable, because price changes are a function of new information
which is unpredictable
§ ∆Pt = Pt – Pt-1 = et
- Example: Suppose model predicts that XYZ stock price, currently $100, will rise dramatically in three days to
$110
o What will all investors with access to the model’s prediction do today? à buy à price increases
immediately
- Whether markets are efficient has been extensively researched and remains controversial
Efficient market hypothesis: EHM
- Stocks already reflect all available information
Why does it matter?
- If prices do fully reflect all current information, it would not be worth an investor’s time to use information to
find undervalued securities
o Y = 0, P = V
- If prices do NOT fully reflect information
o Find and use that information, and perhaps you will be able to beat the market
101
, o Y≠0 à Y of individual asset is not 0 à Y of portfolio is also not 0
o P≠V
Example 1: Cumulative Abnormal Returns Surrounding Takeover
Attempts
- Impact on company that will be taken over
o From literature it’s known that the value of the
company will increase
- Result: when it is known that the company will be taken over,
you will buy, because you expect price to increase
Do markets seem efficient? Do markets reflect the information?
- t = 0: announcement about takeover
o Everyone has access to this information
o On day of announcement cum. abnormal return
increases substantially
- After t = 0: cum. abnormal return is flat, there is no impact of
the announcement anymore the day after à information is
immediately reflected in the price
- Days before the announcement, cum. abnormal returns are
already positive
o Indicates that markets are not fully efficient, because
effect is not only on time t = 0
o Reason: some people have information about potential
takeover (inside information)
Example 2: Returns Following CNBC report announcements
- At t = 0 information has been made public
- Graph looks at minutes relative to the announcement
Do markets seem efficient? Do markets reflect the information?
- On the same minute that announcement has been made, the
markets adjust
o Indication of highly efficient markets
- Positive information: only a reaction in the minute of the
announcement, not later
- Negative information: also a reaction a few minutes later
o Takes a bit more time to reflect information in the price
Example 3: Market response to Covid-19 vaccine announcement by
Pfizer on November 9
- Impact of announcement made by Pfizer during covid-19 crisis
that they made a vaccine
- Very positive news
Do markets seem efficient? Do markets reflect the information?
- Prices go up immediately at the time of the announcement
- Hours after announcement, there is almost no more impact
- Strong indication of efficient market
Investing and Market Efficiency: Would stock selection amount to throwing darts at a wall in an efficient market?
- Hardly! Risk still matters à We would still want to research the risk-return properties of securities
- It’s not because markets are efficient that you can select stocks at random
- You still need to take into account risk
102
, Why Should Capital Markets Be Efficient?
What would be ingredients of “informationally” efficient market?
3 conditions:
- Competition: Large number of profit-maximizing participants analyze and value securities
o Looking for information which might be overlooked by the rest of the investment company
- New information regarding securities comes to the market in a random fashion
o New information is not predictable, thus prices neither
- Profit-maximizing investors adjust security prices rapidly to reflect the effect of this new information
Under these 3 conditions, a security’s price would be appropriate for its level of risk
- Degree of efficiency differs across markets
o Emerging markets might be less efficient than e.g. US markets
§ Reason: less competition à Less investors are following these markets and invest in these
markets
o Prices of small stocks might reflect information less well than prices of large stocks
§ Reason: less competition à Less investors are following these stocks and invest in these stocks
- Inside information
o Illegal
Alternative Efficient Market Hypotheses
Pt ~ f(info)
- Market info (prices, returns, volume, …) included in price of the market à Weak-form EMH
- Public information included in price of the market à Semi strong-form EMH
- Public and private information included in price of the market à Strong-form EMH
o Private information is not available to everyone
Various forms of efficient market hypothesis (EHM):
- Weak-form EMH
- Semi strong-form EMH
- Strong-form EMH
Differences
- Hypotheses differ in terms of the information that security prices should reflect
Weak-form EMH
Pt ~ f(market info)
- Current stock prices already fully reflect all information contained in the history of past trading
- Information: History of past prices, returns and trading volume
- Reason: Past stock price data are publicly available and virtually costless to obtain
- Implication: Past returns and other market data should have no relationship with future returns
o It’s not possible to make predictions about future prices and returns, based on past prices and returns
o Rt = Y + Zrt-1 + ut à ^Z would be insignificant, impossible to predict future with past
- Future returns are unpredictable, based on past returns
EMU Stock Returns
- Technical analysis: looking for pattern in the prices
o Shouldn’t be possible according to weak-form EMH
- Return of European stock market randomly fluctuates
o Result: it would be very difficult to find a pattern to
predict the future
o The random pattern reflects the random
information
103
Review of Previous Topics
- Previous chapters: Determining or modelling expected rates of return
o Average of historical returns
o Scenario analysis
o Index models
o Equilibrium models (CAPM)
§ Different from other models, because it is a theoretical model that states that expected return is
a function of risk
§ Explains how expected return is linked to risk
o Valuation models (Next Part)
- Equilibrium models (CAPM) imply that you get “value for money”: expected return as compensation for risk
o Other methods not necessarily
Market Efficiency
Efficient market
- Price you pay for an asset equals the fair value à Pt = Vt
o Implication: Y = 0 à E(r) = k = rf + Z[E(rm) + rf]
- Investors behave rationally
Inefficient market
- Pt ≠ Vt
- Examples: IT bubble, price of IT stocks was much higher than fair value of those companies
o Everyone bought IT stocks, resulting in increasing prices
- Investors do not act in a rational way
- Implication: Y ≠ 0
o Y < 0 à stocks are overpriced (cf. IT stocks)
o Y > 0 à stocks are underpriced, interesting investment opportunity
Active versus passive management
Assumption: equilibrium models (CAPM) hold
- Result: optimal risky portfolio = market portfolio, all investors invest in this market portfolio, there should thus
be only 1 fund that has the market portfolio, and active management is not useful
- Passive management is appropriate
o CAPM: all Y = 0 à all stocks are correctly priced à by investing in individual assets, it’s not possible to
make an additional profit
- Investment strategy: market index fund (no analysis needed)
Active management: Can you do better?
- Asset allocation: optimal portfolio selection based on asset classes
o Use method to determine input parameters
- Security selection: optimal portfolio selection based on individual assets
o Use valuation methods
- Yp = Y of the portfolio = weighted average of Y’s of individual assets
Better than what?
- Active management should lead to higher returns (abnormal returns)
o Actual return > return as compensation for market risk (positive ex-post Y)
o Return higher than benchmark return (mostly the market)
- How outperform the market?
o Your information must be better than the market
100
, o You should have access to information that isn’t available in the market
o P: Value of stock reflected by the market
§ Price that all investors in the market believe is the correct price
§ Decided by demand and supply
o V: Value of the stock based on your own information
o P = V à You would expect that your information is already reflected in the market
o Suppose at time t: Pt = 100 and Vt = 110 à P ≠ V (not possible in an efficient market)
§ Perhaps you know that the company will do a profitable investment, and only you and the CEO
have access to this information à inefficient market
§ Y = +10%
- If you can’t outperform the market, it doesn’t make sense to manage actively
What is reflected by the market?
- Market efficiency concepts
Efficient Capital Markets
- In an efficient capital market:
o Security prices adjust rapidly to the arrival of new information
o Current prices reflect all information about the security
o Implication: Stock prices should follow a random walk
§ Stock price changes are random and unpredictable
§ Random walk: Pt = Pt-1 + et where ei reflects new information
• New information is random
• In efficient markets, this new information is reflected in the price immediately
§ Reason: At the time that there is new information, everyone (rational investors) will start
buying/selling and the price adjusts immediately, thus by the time you want to buy/sell, the
price is already adjusted
o Result: price changes are not predictable, because price changes are a function of new information
which is unpredictable
§ ∆Pt = Pt – Pt-1 = et
- Example: Suppose model predicts that XYZ stock price, currently $100, will rise dramatically in three days to
$110
o What will all investors with access to the model’s prediction do today? à buy à price increases
immediately
- Whether markets are efficient has been extensively researched and remains controversial
Efficient market hypothesis: EHM
- Stocks already reflect all available information
Why does it matter?
- If prices do fully reflect all current information, it would not be worth an investor’s time to use information to
find undervalued securities
o Y = 0, P = V
- If prices do NOT fully reflect information
o Find and use that information, and perhaps you will be able to beat the market
101
, o Y≠0 à Y of individual asset is not 0 à Y of portfolio is also not 0
o P≠V
Example 1: Cumulative Abnormal Returns Surrounding Takeover
Attempts
- Impact on company that will be taken over
o From literature it’s known that the value of the
company will increase
- Result: when it is known that the company will be taken over,
you will buy, because you expect price to increase
Do markets seem efficient? Do markets reflect the information?
- t = 0: announcement about takeover
o Everyone has access to this information
o On day of announcement cum. abnormal return
increases substantially
- After t = 0: cum. abnormal return is flat, there is no impact of
the announcement anymore the day after à information is
immediately reflected in the price
- Days before the announcement, cum. abnormal returns are
already positive
o Indicates that markets are not fully efficient, because
effect is not only on time t = 0
o Reason: some people have information about potential
takeover (inside information)
Example 2: Returns Following CNBC report announcements
- At t = 0 information has been made public
- Graph looks at minutes relative to the announcement
Do markets seem efficient? Do markets reflect the information?
- On the same minute that announcement has been made, the
markets adjust
o Indication of highly efficient markets
- Positive information: only a reaction in the minute of the
announcement, not later
- Negative information: also a reaction a few minutes later
o Takes a bit more time to reflect information in the price
Example 3: Market response to Covid-19 vaccine announcement by
Pfizer on November 9
- Impact of announcement made by Pfizer during covid-19 crisis
that they made a vaccine
- Very positive news
Do markets seem efficient? Do markets reflect the information?
- Prices go up immediately at the time of the announcement
- Hours after announcement, there is almost no more impact
- Strong indication of efficient market
Investing and Market Efficiency: Would stock selection amount to throwing darts at a wall in an efficient market?
- Hardly! Risk still matters à We would still want to research the risk-return properties of securities
- It’s not because markets are efficient that you can select stocks at random
- You still need to take into account risk
102
, Why Should Capital Markets Be Efficient?
What would be ingredients of “informationally” efficient market?
3 conditions:
- Competition: Large number of profit-maximizing participants analyze and value securities
o Looking for information which might be overlooked by the rest of the investment company
- New information regarding securities comes to the market in a random fashion
o New information is not predictable, thus prices neither
- Profit-maximizing investors adjust security prices rapidly to reflect the effect of this new information
Under these 3 conditions, a security’s price would be appropriate for its level of risk
- Degree of efficiency differs across markets
o Emerging markets might be less efficient than e.g. US markets
§ Reason: less competition à Less investors are following these markets and invest in these
markets
o Prices of small stocks might reflect information less well than prices of large stocks
§ Reason: less competition à Less investors are following these stocks and invest in these stocks
- Inside information
o Illegal
Alternative Efficient Market Hypotheses
Pt ~ f(info)
- Market info (prices, returns, volume, …) included in price of the market à Weak-form EMH
- Public information included in price of the market à Semi strong-form EMH
- Public and private information included in price of the market à Strong-form EMH
o Private information is not available to everyone
Various forms of efficient market hypothesis (EHM):
- Weak-form EMH
- Semi strong-form EMH
- Strong-form EMH
Differences
- Hypotheses differ in terms of the information that security prices should reflect
Weak-form EMH
Pt ~ f(market info)
- Current stock prices already fully reflect all information contained in the history of past trading
- Information: History of past prices, returns and trading volume
- Reason: Past stock price data are publicly available and virtually costless to obtain
- Implication: Past returns and other market data should have no relationship with future returns
o It’s not possible to make predictions about future prices and returns, based on past prices and returns
o Rt = Y + Zrt-1 + ut à ^Z would be insignificant, impossible to predict future with past
- Future returns are unpredictable, based on past returns
EMU Stock Returns
- Technical analysis: looking for pattern in the prices
o Shouldn’t be possible according to weak-form EMH
- Return of European stock market randomly fluctuates
o Result: it would be very difficult to find a pattern to
predict the future
o The random pattern reflects the random
information
103
