Chapter 10: Market Efficiency and Behavioral Finance

1. Chapter 10:Market Efficiency and Behavioral Finance Corporate Finance, 3e Graham, Smart, and Megginson

2. Efficient Financial Markets • Informational efficiency • The efficient markets hypothesis (EMH) asserts that financial asset prices fully reflect all available information.

3. Forms of Market Efficiency • Weak-form efficiency: • Prices will be unpredictable and will change only in response to new information. • This means prices follow a random walk.

4. Forms of Market Efficiency • Semistrong-form efficiency • Asset prices incorporate all publicly available information • Thelevel of asset prices should correctly reflect all pertinent historical, current, and predictable future information obtainable from public sources. • Asset prices should changefully and instantaneously in response to relevant new information.

5. Semi-strong form efficiency uses “all public information” as its definition of “information.” Semistrong-Form Efficiency and Fundamental Analysis Recall the definition of efficient markets: In an efficient market, prices rapidly incorporate all relevant information. Prices move so fast in response to public information that trading on it profitably is nearly impossible!

6. The Strong Form of Market Efficiency Prices should reflect all information, public and private. • Usually tested by seeing if corporate insiders earn superior returns on their trades in company stock • Evidence suggests insiders can “beat the market.” Insiders’ decision to trade at corporate level may be informative.

7. Empirical Evidence on Market Efficiency • Tests for return predictability • Tests of simple trading rules • Tests of the effectiveness of technical analysis • Tests for return continuations or reversals • Tests of the performance of newly issued shares • High initial IPO returns followed by subpar longer-term performance

8. Tests for Rapid Price Adjustment • Event study • Event time rather than calendar time • Firms that split their stock do so after an extended period when their stock earns above-market returns. • After the split stock earns returns roughly equal to those of the overall market. • Markets are efficient: investors who buy shares after split announcements do not earn above-market returns.

9. Tests for Private Information 9 Tests of the Profitability of Insider Trading Tests of Mutual Fund Investment Performance Selectivity Timing

10. Tests for Private Information 10 Tests of Pension Fund and Hedge Fund Investment Performance Tests of the Stock-Picking Abilities of Security Analysts

11. The Behavioral Finance Critiqueof Market Efficiency • Behavioral finance: financial markets are irrationally volatile • traders in financial markets are human beings subject to all the foibles and fads of human judgment in other spheres of life. • Human errors do not simply “cancel out” in markets, but cause prices to deviate far from “fundamental value” in ways that market competition does not immediately eliminate.

12. The Behavioral Finance Critiqueof Market Efficiency • An information cascade occurs when a piece of “information” rapidly travels through a large group of market participants, influencing trading behavior and being accepted as correct—whether it is or not. • All three of these phenomena, if they in fact exist, are inconsistent with market efficiency.

13. Behavioral Finance Argues that market participants suffer from systematic psychological biases that result in suboptimal decisions Investors underreact to new information that contradicts prior beliefs (e.g., dramatic change in earnings). Investors overreact to a string of similar information (e.g., investors expect recent trends to continue). Investors are overly confident in their ability to identify misvalued stocks.

14. The Underreaction Phenomenon Stock Price Momentum The line that is going upward is showing the returns on a group of stocks that have (in month 0) reported unexpectedly high earnings. The line that is trending down is showing the returns on a group of stocks that have (in month 0) reported unexpectedly low earnings. 0 Cumulative Abnormal Return -5 -4 -3 -2 -1 0 +1 +2 +3 +4 +5 Time (months) Investors are underreacting to the recent good (bad) earnings news. Subsequent news after the announcement continues to be good (bad), so investors didn’t fully realize how good (bad) the initial announcement was.

15. Stock Price Momentum 0 Cumulative Abnormal Return -5 -4 -3 -2 -1 0 +1 +2 +3 +4 +5 Time (years) The Overreaction Phenomenon The line that trends up and then reverses represents returns on stocks that have performed very well for the last several years, and vice versa for the other line. The time period we are looking at here is long (several years) and investors are overreacting to a perceived long-term trend. This is distinct from the previous slide where investors were (over a much shorter time span) underreacting to brand new information.

16. Theoretical Underpinnings of Behavioral Finance There is no fully developed model of behavioral finance, but behaviorists have explained how markets might be less than fully efficient.

17. Assessing Behavioral Finance and Market Efficiency Behaviorists present persuasive evidence that price bubbles occur, and somewhat less compelling evidence that the U.S. stock market was grossly overvalued near the turn of the century. On balance, investors and managers are wise to take the efficient markets hypothesis seriously.

18. What Does Market Efficiency Imply for Corporate Financing? How do markets process accounting and other information releases? How do markets respond to corporate financing announcements?

19. Communication Strategy How can managers devise a corporate “communications” policy? Assume that your words and actions have consequences. Assume that loose lips sink corporate ships. Consider honesty to be the best policy. Listen to your stock price.