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The Efficient Capital Markets(chapter 12 Jones)

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Efficient Markets How well do markets respond to new information? Should it be possible to decide between a profitable and

unprofitable investment given current information? Efficient Markets◦ The prices of all securities quickly and fully reflect all available

information

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Conditions for an Efficient Market Large number of rational, profit-maximizing investors◦Actively participate in the market◦ Individuals cannot affect market prices

Information is costless, widely available, generated in a random fashion

Investors react quickly and fully to new information

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Consequences of Efficient Market Quick price adjustment in response to the arrival of

random information makes the reward for analysis low Prices reflect all available information Price changes are independent of one another and move

in a random fashion◦New information is independent of past

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Alternative Efficient Market HypothesesThe various forms of the efficient market hypothesis differ in terms

of the information that security prices should reflect. Weak-form EMH Semistrong-form EMH Strong-form EMH

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Weak-Form EMH Current prices fully reflect all security-market information, including the

historical sequence of prices, rates of return, trading volume data, and other market-generated information

This implies that past rates of return and other market data should have no relationship with future rates of return

Implication: Examining recent trends in price and other market data (called Technical analysis)

in order to predict future price changes would be a waste of time if the market is weak-form efficient

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Tests and Results: Weak-Form EMHProblems with tests Cannot be definitive since trading rules can be complex and there

are too many to test them all Testing constraints

- Use only publicly available data- Should include all transactions costs- Should adjust the results for risk (an apparently successful

strategy may just be a very risky strategy)

If someone writes a book on how to “beat the market,” you can bet that book sales are more lucrative than the trading strategy!Even if it once worked, if it’s widely known, it won’t work any more!

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Semistrong-Form EMH Current security prices reflect all public information, including market and non-

market information This implies that decisions made on new information after it is public should

not lead to above-average risk-adjusted profits from those transactions

Implication:

If the market is efficient in this sense, information in The Wall Street Journal, other periodicals, and even company annual reports is already fully reflected in prices, and therefore not useful for predicting future price changes.

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Strong-Form EMH Stock prices fully reflect all information from public and private

sources

Implication:

Not even “insiders” would be able to “beat the market” on a consistent basis

Evidence does not support strong form EMH.Insiders can make a profit on their knowledge, and people go to jail, get fined, or get suspended from trading for doing so.

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Anomalies

The low PE effect : Some evidence indicates that low PE stocks outperform higher PE stocks of similar risk.

Low-priced stocks : Many people believe that the price of every stock has an optimum trading range.

The small firm effect : Small firms seem to provide superior risk-adjusted returns.

The neglected firm effect : Neglected firms seem to offer superior returns with surprising regularity

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AnomaliesMarket Overreaction and Momentum : It is observed that the market tends to overreact to extreme news. So, systematic price reversals can sometimes be predicted.

Security Analysts This looks at whether, after a stock selection by an analyst is made known, a

significant abnormal return is available to those who follow their recommendation

There is some evidence of superior analysts, and as a group the stocks with better analysts ratings have better returns

The Value Line Enigma- Advisory service that ranks 1700 stocks from best (1) to worst (5)

Probable price performance in next 12 months- 1980-1993, Group 1 stocks had annualized return of 19.3%

Best investment letter performance overall

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Other Tests and ResultsProfessional Money Managers If any investor can achieve above-average returns, it should be this

group If any non-insider can obtain inside information, it would be this

group due to the extensive management interviews that they conduct Risk-adjusted returns of mutual funds generally show that most

funds did not match aggregate market performance

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The Rationale and Use of Index Funds(passive investing)

Efficient capital markets and a lack of superior analysts imply that many portfolios should be managed passively (so their performance matches the aggregate market, minimizes the costs of research and trading)

Institutions created market (index) funds which duplicate the composition and performance of a selected index series

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Behavioral Finance

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Behavioral Finance vs Standard Finance

Behavioral finance considers how various psychological traits affect investors

Behavioral finance recognizes that the standard finance model of rational behavior can be true within specific boundaries but argues that this model is incomplete since it does not consider the individual behavior.

Currently there is no unified theory of behavioral finance, thus the emphasis has been on identifying investment anomalies that can beexplained by various psychological traits.

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Loss Aversion and Mental Accounting

First decision: Choose between

Choice 1: sure gain of $ 85,000 Choice 2: 85% chance of receiving $100,000 and 15% chance of receiving nothing

Second decision: Choose between

Choice 1: sure loss of $ 85,000 Choice 2: 85% chance of losing $100,000 and 15% chance of losing nothing

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Mental Accounting

Individuals tend to keep a mental account for each investment option, instead of looking at the investment decisions as a “package”

Many investors are highly risk averse with money in some accounts and risk lovers with money in other accounts

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Mental Accounting: sunk costsYou have a ticket to a Dodgers game, ticket worth $60. On the day

of the game there is a big rain. Although you can still go to the game and the game is playing, the rain will reduce the pleasure of watching the game. Are you more likely to go to the game if you purchased the ticket or if the ticket was given to you for free?

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Seeking pride and avoiding regret

Rational individuals feel no greater disappointment when theymiss their plane by a minute as when they miss it by an hour.What about most of us?

Most of the investors sell winners too early, riding losers too long (called the disposition effect)

Individuals who make decisions that turn out badly have more regret when that decisions were more unconventional