efficient market hypothesis vs. behavioral finance

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Efficient Market Hypothesis vs. Behavioral Finance

Market Efficiency Random walk versus market efficiency Versions of market efficiency Technical analysis vs. fundamental analysis Predictors of future returns and market anomalies Behavioral finance

Market Efficiency and Behavioral Finance

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Cumulative Abnormal Returns Around Takeover Attempts: Target Companies


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Stock Price Reaction to CNBC Reports


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Stock prices fully and accurately reflect publicly available information.

Once information becomes available, market participants analyze it.

Competition assures prices reflect information. What does competition mean here? -- page 351 Is there a role for active portfolio management in

an efficient market?

EMH and Competition


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Weak Semi-strong Strong

See page 347-348.

Forms of the EMH


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Technical Analysis - using prices and volume information to predict future prices. Weak form efficiency & technical analysis Chartist Relative strength versus resistance levels

Fundamental Analysis - using economic and accounting information to predict stock prices. Semi strong form efficiency & fundamental analysis

Types of Stock Analysis


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Technical Analysis

Relative strength – page 348 Resistance levels – upper bound or Support levels – lower bound Whether a workable technical trading rule will

continue to work in the future once it becomes publicly known?


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Fundamental Analysis

Uses earnings and dividend prospects of the firm, expectations of future interest rates, and risk evaluation of the firm to determine proper stock prices.

Fundamental analysis is much beyond identifying well-run firms with good prospects. It is to identify companies better than every else’s estimate.


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Active Management Security analysis Timing

Passive Management Buy and Hold Index Funds

Active or Passive Management


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Even if the market is efficient a role exists for portfolio management:

Appropriate risk level Tax considerations Other considerations

Market Efficiency & Portfolio Management


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Event studies Assessing performance of professional managers Testing some trading rule

Empirical Tests of Market Efficiency


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Magnitude Issue Selection Bias Issue: investing in small stocks Lucky Event Issue

Issues in Examining the Results


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Weak-Form Tests

Serial Correlation Momentum Returns over Long Horizons


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Experience with 911 Anticipating market chaos, panic selling and a disastrous loss of value in the wake of the attacks,

the NYSE and the Nasdaq remained closed until September 17, the longest shutdown since 1933. Moreover, many trading, brokerage and other financial firms had offices in the World Trade Center and were unable to function in the wake of the tragic loss of life and collapse of both towers.

On the first day of NYSE trading after 9/11, the market fell 684 points, a 7.1% decline, setting a record for the biggest loss in exchange history for one trading day. At the close of trading that Friday, ending a week that saw the biggest losses in NYSE history, the Dow Jones was down almost 1,370 points, representing a loss of over 14%.

Major stock sell-offs hit the airline and insurance sectors as anticipated when trading resumed. Hardest hit were American Airlines and United Airlines, carriers whose planes were hijacked for the terrorist attacks.

American Airlines (NYSE:AMR) stock dropped from a $29.70 per share close of September 11 to $18.00 per share close on September 17, a 39% decline. United Airlines (NYSE:UAL) stock dropped from $30.82 per share close to $17.50 per share on the close on September 17, a 42% decline.


http://www.investopedia.com/terms/s/sell-off.asp

http://www.investopedia.com/markets/stocks/AMR

http://www.investopedia.com/markets/stocks/UAL

15Market Efficiency and Behavioral Finance

Also: Program trading; algorithmic trading; and high-frequency trading:According to the New York Stock Exchange, in 2006 program trading accounts for about 30% and as high as 46.4% of the trading volume on that exchange every day.http://www.programtrading.com/The greatest point loss of the Dow Jones Industrial Average was 777.68 points on September 29, 2008.

http://www.programtrading.com/

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Predictors of Broad Market Returns

Fama and French Aggregate returns are higher with higher dividend

ratios Campbell and Shiller

Earnings yield can predict market returns Keim and Stambaugh

Bond spreads can predict market returns


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P/E Effect Small Firm Effect (January Effect) Neglected Firm Book-to-Market Effects Post-Earnings Announcement Drift

http://biz.yahoo.com/research/earncal/today.html

Anomalies


http://biz.yahoo.com/research/earncal/today.html

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Returns in Excess of Risk-Free Rate and in excess of the Security Market Line for 10 Size-Based Portfolios, 1926 – 2005


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Average Monthly Returns as a Function of the Book-To Market Ratio, 1963 – 2004


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Cumulative Abnormal Returns in Response to Earnings Announcements


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Some evidence of persistent positive and negative performance.

Potential measurement error for benchmark returns. Style changes May be risk premiums

Mutual Fund Performance


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Persistence of Mutual Fund Performance


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Behavioral Finance

The premise of behavioral finance is that conventional financial theory ignores how real people make decisions and that people make a difference.

Investors Do Not Always Process Information Correctly

Investors Often Make Inconsistent or Systematically Suboptimal Decisions


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Behavioral Biases Framing

Decisions seem to be affected by how choices are framed – page 387 example

Mental Accounting A special form of framing in which people segregate certain decisions example

Regret Avoidance Individuals would have more regrets when their decisions are more

unconventional example

Prospect Theory Traders become risk seeking after they lose money


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Prospect Theory Graphs


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Prospect theory (2)

Loss aversion: utility depends not on the level of wealth from current levels.

The convex curvature to the left of the origin will induce investors to be risk seeking rather risk averse when it comes to losses

Traders in T-bond futures often take significantly greater risk in afternoon sessions following morning sessions in which they have lost money


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Limits to Arbitrage

Fundamental Risk Implementation Costs Model Risk


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Limits to Arbitrage and the Law of One Price

Violations Siamese Twin Companies Equity Carve-outs Closed-End Funds


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Bubbles and Market Efficiency The bust of dot-com bubble Financial crisis – housing price bubble

Hard to be justified by the position that security prices represent rational, unbiased assessments of intrinsic value.

Dynamic risk taking – excessive risk taking in bubble period


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Technical Analysis and Behavioral Finance

Trends and corrections momentum (page 393) Dow theory: primary trend, secondary trend, and

tertiary trend see Figure 12-4

Moving averages Breadth: the spread between the number of stocks

that advance and decline in price.


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Technical Analysis and Behavioral Finance

Trin statistic Confidence index Put/call ratio


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Investment-based CAPM

Cochrane (1991, 1996) Low costs of capital imply high NPV of new

projects and high investment High costs of capital imply low NPV of new

project and low investment Inverse relationship between expected return and

investments


efficient market hypothesis vs. behavioral finance

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