The Investment Background by yurtgc548


									Efficient Markets and
  Behavioral Critique

   Market in which securities prices reflect all available
    ◦ all securities are fairly priced
    ◦ Investors get exactly what they pay for
    ◦ Firms get exactly what their stocks and bonds are worth when they sell
   FCC Corporation is developing a camera that will double the
    speed of the auto-focusing system. It is highly profitable and
    the NPV will be positive.
   Day 0 represents the announcement day. Before the
    announcement day, FCC’s stock sells for $140 per share. The
    NPV per share is $40, so the new price will be $180 once the
    value of the new project is fully reflected.
   Hence, the solid line represents the path of stock price in an
    efficient market. The price will adjust immediately and no
    further change in the price of stock will take place later.
   The broken line represents a delayed reaction. It takes 8 day
    for the market to fully incorporate the information.
   The dotted line indicates an overreaction and subsequent
    adjustment to the correct price
   Broken and dotted line show the path of the stock price if
    markets are inefficient.
majority of the profit is in the
first 30 minutes
   Stock prices fully and accurately reflect
    publicly available information
   Once information becomes available,
    market participants analyze it
   Competition assures prices reflect
• Weak-form EMH: prices reflect all past info
• Semistrong-form EMH: prices reflect all public
       (past&current) info
• Strong-form EMH: prices reflect all (past&current,
       public&private) info

                           Form      Form
   Weak-form:
    ◦ price reflect all past info.
    ◦ using historical data to predict future prices is useless
   Semi-strong form
    ◦ price reflect all public info (current and past)
    ◦ using historical data and available financial statement to predict future
      price is useless
   Strong form
    ◦ price reflect all information: past, public and private
    ◦ cannot predict price even with inside information
   Technical Analysis - using prices and
    volume information to predict future
    ◦ Weak form efficiency & technical
   Fundamental Analysis - using economic
    and accounting information to predict
    stock prices
    ◦ Semi strong form efficiency &
      fundamental analysis
   Price change randomly or follow a random walk. Why?
   EMH: price is in equilibrium or reflect the true value
    ◦ Price < true value: more investors to buy, push the price up to the true
    ◦ Price > true value: more sell, drive the price down to the true level
    ◦ Price will stay at the true level if there is no new info
   New info, price will change accordingly
   New information is unpredictable
   stock price change is unpredictable
   using past info to search for patterns in stock prices to identify
    mispriced stocks
   EMH implies that technical analysis is useless because all past
    info is incorporated in current stock price. If one knows about
    the pattern, other people will also know
   Example: you believe that you discover a pattern in stock
    price, the price should be $50 instead of current price is 45.
    ◦ you want to buy stock at 45 and sell it tomorrow for 50. Is it possible?
    ◦ If you know, sellers also know about it, the price will be pushed up to 50
      before you can buy the stock
   Technical: look back at the past to forecast future price
   Fundamental: look ahead to forecast future info and then forecast true
    price. To forecast stock price, we need future cash flow and discount rate
    ◦ Use available financial statement to forecast earnings and dividends perspectives
      of the firms
    ◦ Calculate risk of firm, using CAPM to get the discount rate
    ◦ calculate the true value and compare with current price
         current price > true
         Current price < true
   EMH suggest that fundamental adds little value
    ◦   public info is available to everyone
    ◦   not much difference in analysts’ reports
    ◦   price reflect true value
    ◦   must be better than other analysts to make abnormal profit
   Active: attempt to find mispriced securities
   Passive: no attempt, just buy and hold a well-diversified
   EMH: active is wasted effort
    ◦ securities are fairly priced
    ◦ lose transaction cost
   Example: create a portfolio that follows the index S&P 500
• Technical Analysis: useless
• Fundamental Analysis: adds little value
• Active versus Passive Portfolio
  Management: passive wins

EMH        You can’t “Beat the Market”
   Efficient markets do not mean that you can’t
    make money
   They do mean that, on average, you will earn a
    return that is appropriate for the risk
    undertaken and there is not a bias in prices
    that can be exploited to earn excess returns
   Market efficiency will not protect you from
    wrong choices if you do not diversify – you still
    don’t want to put all your eggs in one basket
   Need for a well-diversified portfolio:
   Tax considerations
    ◦ high tax-bracket: prefer municipal bond
    ◦ high tax-bracket: prefer securities that provide capital gains as opposed
      to interest income since gains are tax less heavily
   Individual considerations
    ◦ GM executives, performance depends on GM stocks, should not invest
      too much in auto stocks
   Age considerations
    ◦ older investors might avoid long-term bond
    ◦ younger might choose long-term bond
Hard question!

 • The Magnitude Issue

 • The Selection Bias Issue

 • The Lucky Event Issue
   You manage a portfolio $1 billion. If the return is 0.1%/year,
    should make 1 mil/year.
    ◦ A very small deviation from the true price can result in large profit
    ◦ Standard deviation of S&P 500/ year = 20%
    ◦ When a manager makes a lot of money on a large portfolio, does it mean
      the market is not efficient?
   When you discover a technique to beat the market, should you
    ◦ publish it to get reputation
    ◦ keep it as secrets to make money
   Technique available in the market is the one that cannot make
    abnormal profit
   EMH only looks at those techniques available in market, and
    conclude that these cannot beat the market, it is not necessarily
   Read WSJ, some investors outperform others, is this evidence
    against EMH?
   Flip a fair coin, 50% head, 50% tail, 50 times, on average, will
    get 25 times H, 25 times T.
   If someone can get more than 25 times H, does it mean he is
    better than you?
   short-horizon (<1 year): rank stocks based on past performance
    ◦   Winner
    ◦   Loser
    ◦   Next 3-12 months, winners continue to outperform losers
    ◦   Momentum strategy
   Long horizon
    ◦ reversal effect, loser outperform winner
    ◦ Contrarian strategies
   Fad hypothesis
    ◦ short term: market overreact to news, sell more losers, price(losers) < true level,
      buy more winner, price(winner) > true level. Therefore, winner continue to
      outperform loser
    ◦ Long term: market makes correction, price of loser goes back up to the true
      level, winner goes back down to the true level, loser outperform winner
   Fama and French
    ◦ Aggregate returns are higher with
      higher dividend ratios
   Campbell and Shiller
    ◦ Earnings yield can predict market
   Keim and Stambaugh
    ◦ Bond spreads can predict market
   Anomalies: evidence that contradicts EMH
   P/E Effect: low P/E, High returns,
    Small-firm-in-January effect: Small firm, High return, in
   Neglected-Firm Effect: Less known firms have higher return,
    Book-to-Market effect: high B/M, high returns
    Post-earnings effect: sluggish response of price to earnings
   Studies of returns in the US and other major
    financial markets reveal strong difference in
    return behaviors across months of the year
   Returns in January is much stronger than
    returns in any other month of the year. This
    is called January effect and most of the
    January effect can be traced to the first 2
    weeks of January
   The January effect is much more
    accentuated for small firms than for large
   Tax-loss selling by investors: at the end of the year
    when investors, starting to worry about taxes, sell
    some stocks that are down so the losses can be
    written off against capital gains. This selling causes
    stocks to go down near the end of the year and
    back up in January when investors buy back the
    stocks they sold.
   The weekend effect is another phenomenon that
    has persisted over time in the US as well as in
    international markets. It refers to the differences in
    Monday return and the return of other days in the
   Over the year, the return on Monday has been
    consistently lower than the return of other days in
    the week
   the weekend effect might be the results of bad
    news being revealed after Friday close and during
    the weekend.
   Others state that the weekend effect might be
    linked to short selling, which would affect stocks
    with high short interest positions. Or, the effect
    could simply be a result of traders'
    fading optimism between Friday and Monday.
   May be attributed to absence of trading over the
    weekend. However, this should not be the reason if
    we consider the return after the holidays. Usually,
    the returns after holidays are positive not negative
   Form stocks into 10 portfolios based on magnitude of earning
    surprise (difference between historical analysts’ forecast and
    actual announcement) Portfolio 1 being the lowest, 10 being
    the highest.
   Positive surprise firms continue to have positive abnormal
    return. Negative surprise firms continue to have negative
    abnormal return
   higher surprise has higher abnormal return
   No explanation so far.
• Most tests require risk adjustments
• Risk adjustment require a model of risk
 (typically uses CAPM)
• Tests of risk-adjusted returns are joint tests
 of the EMH and the risk adjustment procedure
• Rejecting risk-adjustment procedure leaves
  no conclusions about EMH
EMH is essentially untestable.
   With private info, can we beat the market?
   The ability of insiders to trade profitability in their
    own stock has been documented in studies by
    Jaffe, Seyhun, Givoly, and Palmon
   SEC regulations
    ◦ insider register all trading activities
    ◦ publish all these trades
    ◦ insider must report large trades to SEC within 2 days
   Anomalies: momentum, contrarian, size, book-to-market, P/E
    ratio, post announcement drift, etc.
    ◦ Evidence against EMH
    ◦ market is efficient but sources of risk are not fully identified
   On going debate
    Mutual fund performance

   Skilled equity investment
professionals do not consistently
        beat the market.
   Example: 2 finance professtionals walk on street, one see $20
    bill, and is going to pick it up, the other says: don’t bother, if it
    was real money, someone else would have picked it up
   The same idea applies to the market
   Market is very competitive, generally efficient.
   However the evidence of anomalies suggest that there might
    be reward for hard-working, intelligent, creative investors.
• Research shows stock prices tend to follow a random walk
• Three forms of the efficient market hypothesis
• Technical analysis
• Fundamental analysis
• Empirical studies have generally shown that technical
  analysis does not generate trading profits
• Several anomalies exist regarding fundamental analysis
• Professionally managed funds generally cannot
  consistently beat the market

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