Challenges to Market Efficiency

7/25/2019 Challenges to Market Efficiency

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CHALLENGES TO

MARKET EFFICIENCY



An efcient market is one in which stockprices fully reect available information.

The EMH has implications for investors and

rms.◦ Since information is reected in security prices

uickly! knowin" information when it isreleased does an investor little "ood.

◦ #irms should e$pect to receive the fair valuefor securities that they sell. #irms cannot protfrom foolin" investors in an e%cient market.

A Description of EcientMarkets



&nvestor 'ationality &ndependence of events Arbitra"e

Fon!ations of MarketEcienc"



Stock #rice Reactions

Stock(rice

)*+ ),+ )-+ + -+ ,+ *+

/ays before 0)1 and after 01announcement

E%cient market

response to 2"oodnews3

4verreaction to2"ood news3 with

reversion/elayed

response to2"ood news3



5eak #orm

◦ Security prices reect all historical information.

Semistron" #orm

◦

Security prices reect all publicly availableinformation.

Stron" #orm

◦ Security prices reect all information6public and

private.

$%&% T'e Di(erent T"pes of

Ecienc"



Security prices reect all informationfound in past prices and volume.

&f the weak form of market e%ciencyholds! then technical analysis is of novalue.

Since stock prices only respond to new

information! which by denition arrivesrandomly! stock prices are said to followa random walk.

)eak For* Market Ecienc"



)'" Tec'nica+ Ana+"sis Fai+s

S t o c

k

( r i c e

Tim

&nvestor behavior tends to eliminate anyprot opportunity associated with stock pricepatterns.

&f it were possible tomake bi" moneysimply by ndin" 2thepattern3 in the stockprice movements!everyone would do it!and the prots wouldbe competed away.

Sell

Sell

7uy

7uy



Security prices reect all publiclyavailable information.

(ublicly available informationincludes8◦ Historical price and volume information

◦ (ublished accountin" statements

◦ &nformation found in annual reports

Se*istron, For* MarketEcienc"



Security prices reect all information6public and private.

Stron" form e%ciency incorporatesweak and semistron" form e%ciency.Stron" form e%ciency says that

anything pertinent to the stock andknown to at least one investor isalready incorporated into thesecurity9s price.

Stron, For* Market Ecienc"



&nvestors can throw darts to selectstocks.◦

This is almost! but not uite! true.◦ An investor must still decide how risky a portfolio

he wants based on risk aversion and e$pectedreturn.

(rices are random or uncaused.◦ (rices reect information.

◦ The price :HA;<E is driven by new information!which by denition arrives randomly.

)'at t'e EMH Does an! Does

NOT Sa"



4ne "roup of studies of stron" formmarket e%ciency investi"ates insidertradin".

A number of studies support the viewthat insider tradin" is abnormallyprotable.

Thus! stron" form e%ciency does notseem to be substantiated by theevidence.

T'e Stron, For* of t'e EMH



:HA==E;<ES

Tradin" strate"ies based on historical priceand volume data have been tested e$tensively!usin" computer pro"rammes. Althou"h the bulk

of the evidence su""ests that such strate"iesare unlikely to be successful! chartists point outthat a computer pro"ramme is >ust thebe"innin". They claim that other sub>ective!

non)uantiable information and analysis arealso needed! and that this sub>ective element isi"nored by the computer pro"rammes?



The time perspective used in academicstudies can be misleadin". =on")term

variations in share prices may be closer to arandom walk 0i.e. unpredictable1 than areshort)term price movements?



The EMH assumes that all investors processnew information in the same way to makerational decisions. 5hile some professional

investors representin" lar"e nancialinstitutions may resort to sophisticatedmethods of nancial analysis! it is unlikely thatall investors make decisions on this basis. &t has

been found that most investors! includin"professionals! have developed simpliedtechniues and rules 0heuristics1 which theyapply when makin" investment decisions. Such

heuristics are sub>ectively felt to be rational andmay "ive satisfactory results! "iven the realitiesof the nancial market



#ollowin" on the above point! it is notunreasonable to assume that all information

may not be used by all investors! or maynot be used by all investors in the sameway. &n this case! there will always beinvestors makin" a prot on the basis of

information. Markets will then be brou"htback towards e%ciency throu"h the tradin"of investors who e$ploit favourable pricedierences?



&t is hard to know whether all relevantinformation is! in fact! available to all

market participants. As #ischo remarked ina -BC, book8 D4ne of my favourite contrastsis that when the market rises followin" "ood

economic news! it is said to be respondin"

to the news? if it falls! that is e$plained bysayin" that the "ood news had already beendiscounted.D



A study by Schachter and other academics in 1986

concluded that a share price is a social fact: "The

price of a stock is more than an objective

rationally developed number! it is an opinion an

areate opinion the moment#to#moment

resultant of the evaluation of the community of

investors$ As an opinion stock price is subject to

the same set of social pressures and cultural

influences as any other opinion such as the

evaluation of a %ork of art the preference of apolitical candidate or the popularity and spread of

a fad$"



#irstly! short)term share price and marketmovements appear to be very di%cult! if notimpossible! to predict with any accuracy.

Secondly! the market reacts uickly and sharply to

new information! and most of the academicstudies nd little evidence that the market over)reacts or under)reacts to new information in away that can be protable e$ploited.

Thirdly! if the stock market can be beaten! the wayto do it is at least not obvious! so the implicationis that the market is not "rossly ine%cient.

t'ree ,enera+ co**entsre,ar!in, *arket ecienc"&



'ationality◦ (eople are not always rational.

◦ Many investors fail to diversify! trade too much!and seem to try to ma$imie ta$es by sellin"

winners and holdin" losers.

$%&- T'e .e'a/iora+ C'a++en,e



&ndependent /eviations from 'ationality◦ (sycholo"ists ar"ue that people deviate from

rationality in predictable ways8

'epresentativeness8 drawin" conclusions

from too little data This can lead to bubbles in security

prices.

:onservativism 8 people are too slow in

ad>ustin" their beliefs to new information. Security prices seem to respond too

slowly to earnin"s surprises.

T'e .e'a/iora+ C'a++en,e



Arbitra"e◦ Suppose that your superior! rational! analysis

shows that company A7: is overpriced.

◦ Arbitra"e would su""est that you should short the

shares.◦ After the rest of the investors come to their senses!

you make money because you were smart enou"hto 2sell hi"h and buy low.3

7ut what if the rest of the investment communitydoesn9t come to their senses in time for you tocover your short positionF

◦ This makes arbitra"e risky.

T'e .e'a/iora+ C'a++en,e



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Challenges to Market Efficiency