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Efficient Market Hypothesis

Efficient Market Hypothesis. An efficient market is one where the market price is an unbiased estimate of the true value of the investment Market value does not equal “true” value Equal chance of under or over-valuation If true, no investor can consistently find under valued stocks.

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Efficient Market Hypothesis

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  1. Efficient Market Hypothesis • An efficient market is one where the market price is an unbiased estimate of the true value of the investment • Market value does not equal “true” value • Equal chance of under or over-valuation • If true, no investor can consistently find under valued stocks Intermediate Investments F305

  2. Types of Market Efficiency • Weak form of efficiency – • Semi-strong form of efficiency – • Strong form of efficiency - Intermediate Investments F305

  3. Implications of Market Efficiency • Can you beat the market? • What are the benefits of equity research? • What is the best strategy? • What is the relationship between risk and return? Intermediate Investments F305

  4. Types of Investment Analysis • Technical Analysis – • Fundamental Analysis – • Mixed Approach – Intermediate Investments F305

  5. Is the Market Rational? Fortune 12/9/02 • In one article we have many of the most famous names in Capital Markets theory • Eugene Fama, U of Chicago • Merton Miller, U of Chicago • Kenneth French, Dartmouth • Richard Thaler, U of Chicago • William Sharpe U. of Stanford, then Wall Street • Sharpe ratio and Beta • Money Manager (to EMH professor): “If you are so smart, why aren’t you rich?” The professor replied, “If you’re so rich, why aren’t you smart?” Intermediate Investments F305

  6. Is the Market Rational? • The “Rational Strategy” (arrives in the late 60’s) • Buy and hold • Diversification • Index fund investments (first retail fund 1976) • Control costs Vs • Behavioral Finance • Investors are irrational • Prices are in part predictable based on past price movements • Careful analysis can pay off! • BUT: Although you can beat the market, you likely won’t so follow a rational strategy! Intermediate Investments F305

  7. Is the Market Rational? • Fama claims market anomalies are bad statistical work • Efficient Market theorists say “the price is right!” • Quote: “One of the most compelling of those models, and the one that seemed most closely to fit real-world data was the Efficient Market Hypothesis. It had its roots in empirical research that appeared to show stocks moving in a random walk-albeit with an upward trajectory for rising corporate earnings. The theoretical explanation…was that stock prices fluctuate randomly because all knowable information about the value of a stock is already discounted in the price and prices change only in reaction to news which is by definition unpredictable. Intermediate Investments F305

  8. Is the Market Rational? • Not everyone is rational, but so many are irrational in different ways they cancel each other out • Behavioralists say that people making investment decisions make “systematic and predictable errors • January effect • Value stocks with low price to book ratios outperform the market • BUT, even behavioralists say • Trade too much • Don’t diversify enough • Count too much on recent past to make future decisions Intermediate Investments F305

  9. Is the Market Rational? • The Behavioralists view the market bubble of the 90’s as proof that investors are not rational • Sharpe, a Rationalist supporter, could not explain the market crash of 1987. He described it as “weird”. His mother later told him, “Fifteen years of education, three advanced degrees and all you can say is ‘It’s weird’?” • CONCLUSIONS? • Even behavioralists assume the markets are efficient when calculating cost of capital • Even EMH supporters admit they need people to try to beat the markets to keep them efficient • So, buy and hold, diversify and control your costs! Intermediate Investments F305

  10. Anomalies in Technical and Fundamental Investing • Technical • Short-term positive correlations • Long-term negative correlations • Small Firms in January effect • Fundamental • Investing for value v. growth • Vishny and Lalinshock • Fama and French Intermediate Investments F305

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