Chapter 10 EFFICIENT CAPITAL MARKETS. Chapter 10 Questions What do we mean when we say that capital markets are efficient?What do we mean when we say

Chapter 10Chapter 10

EFFICIENT CAPITAL MARKETSEFFICIENT CAPITAL MARKETS

Chapter 10 QuestionsChapter 10 Questions

• What do we mean when we say that capital What do we mean when we say that capital markets are efficient?markets are efficient?

• Why should capital markets be efficient?Why should capital markets be efficient?• What factors contribute to an efficient What factors contribute to an efficient

market?market?• Given the overall efficient market hypothesis Given the overall efficient market hypothesis

(EMH), what are the three subhypotheses (EMH), what are the three subhypotheses and what are the implications of each?and what are the implications of each?


• How do we test the three efficient market How do we test the three efficient market subhypotheses, and what are the results of subhypotheses, and what are the results of the tests?the tests?

• For each set of tests, which of the results For each set of tests, which of the results support the EMH and which indicate an support the EMH and which indicate an anomaly related to the hypothesis?anomaly related to the hypothesis?

• What is behavioral finance, and how does it What is behavioral finance, and how does it relate to the EMH?relate to the EMH?


• What are some of the major findings of What are some of the major findings of behavioral finance, and what are the behavioral finance, and what are the implications for the EMH?implications for the EMH?

• What are the implications of the efficient What are the implications of the efficient market test results formarket test results for– Technical analysis?Technical analysis?– Fundamental analysis?Fundamental analysis?– Portfolio managers with superior analysts?Portfolio managers with superior analysts?– Portfolio managers with inferior analysts?Portfolio managers with inferior analysts?

Efficient Capital MarketsEfficient Capital Markets

• In an efficient capital market, security In an efficient capital market, security prices adjust rapidly to the arrival of prices adjust rapidly to the arrival of new information, therefore the current new information, therefore the current prices reflect all information about the prices reflect all information about the securitysecurity

• Whether markets are efficient has been Whether markets are efficient has been extensively researched and remains extensively researched and remains controversialcontroversial

Why does it matter?Why does it matter?

• If prices do fully reflect all current If prices do fully reflect all current information, it would not be worth an information, it would not be worth an investor’s time to use information to find investor’s time to use information to find undervalued securities.undervalued securities.

• If prices do NOT fully reflect If prices do NOT fully reflect information, FIND AND USE THAT information, FIND AND USE THAT INFORMATION, and perhaps you will INFORMATION, and perhaps you will be able to make a killing in the market.be able to make a killing in the market.

Investing and Market Investing and Market EfficiencyEfficiency

• Would stock selection Would stock selection amount to throwing amount to throwing darts at a wall in an darts at a wall in an efficient market?efficient market?

• Hardly! Risk still Hardly! Risk still matters. We would still matters. We would still want to research the want to research the risk-return properties of risk-return properties of securities.securities.

Why Should Capital Why Should Capital Markets Be Efficient?Markets Be Efficient?

• What would be the ingredients of an What would be the ingredients of an “informationally” efficient market?“informationally” efficient market?– A large number of profit-maximizing participants A large number of profit-maximizing participants

analyze and value securitiesanalyze and value securities– New information regarding securities comes to the New information regarding securities comes to the

market in a random fashionmarket in a random fashion– Profit-maximizing investors adjust security prices Profit-maximizing investors adjust security prices

rapidly to reflect the effect of new informationrapidly to reflect the effect of new information• Price adjustments are unbiased – correct on average.Price adjustments are unbiased – correct on average.

• Under these conditions, a security’s price Under these conditions, a security’s price would be appropriate for its level of risk. would be appropriate for its level of risk.

Alternative Efficient Alternative Efficient Market HypothesesMarket Hypotheses

The various forms of the efficient market The various forms of the efficient market hypothesis differ in terms of the hypothesis differ in terms of the information that security prices should information that security prices should reflect.reflect.

• Weak-form EMHWeak-form EMH

• Semistrong-form EMHSemistrong-form EMH

• Strong-form EMHStrong-form EMH

Weak-Form EMHWeak-Form EMH

• Current prices fully reflect all security-Current prices fully reflect all security-market information, including the market information, including the historical sequence of prices, rates of historical sequence of prices, rates of return, trading volume data, and other return, trading volume data, and other market-generated informationmarket-generated information

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

Implications of the Weak-Implications of the Weak-From EMHFrom EMH

• Examining recent Examining recent trends in price and trends in price and other market data in other market data in order to predict future order to predict future price changes would be price changes would be a waste of time if the a waste of time if the market is weak-form market is weak-form efficient.efficient.

• A lot of people do price A lot of people do price charting and other charting and other forms of “technical forms of “technical analysis.”analysis.”

Semistrong-Form EMHSemistrong-Form EMH

• Current security prices reflect all public Current security prices reflect all public information, including market and non-information, including market and non-market informationmarket information

• This implies that decisions made on This implies that decisions made on new information after it is public should new information after it is public should not lead to above-average risk-adjusted not lead to above-average risk-adjusted profits from those transactionsprofits from those transactions

Implications of the Implications of the Semistrong-Form EMHSemistrong-Form EMH

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

Strong-Form EMHStrong-Form EMH

• Stock prices fully reflect all information from Stock prices fully reflect all information from public and private sourcespublic and private sources

• This would require perfect markets in which This would require perfect markets in which all information is cost-free and available to all information is cost-free and available to everyone at the same time (which is clearly everyone at the same time (which is clearly not the case)not the case)

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

Tests and Results: Weak-Tests and Results: Weak-Form EMHForm EMH

Two ApproachesTwo Approaches

• Tests of “statistical memory” in security Tests of “statistical memory” in security prices and returnsprices and returns

• Tests of trading rulesTests of trading rules


• Statistical tests of independence Statistical tests of independence between rates of returnbetween rates of return– Autocorrelation testsAutocorrelation tests

• Mostly support the weak-form EMH and Mostly support the weak-form EMH and indicate that price changes are randomindicate that price changes are random

• Some studies using more securities and more Some studies using more securities and more complicated tests cast some doubtcomplicated tests cast some doubt

– Runs tests Runs tests • Indicate randomness in pricesIndicate randomness in prices


• Comparison of trading rules to a buy-Comparison of trading rules to a buy-and-hold policy and-hold policy – Some filter rules seem yield above-Some filter rules seem yield above-

average profits with small filters, but only average profits with small filters, but only before taking into account the substantial before taking into account the substantial transactions costs involvedtransactions costs involved

– Trading rule results have been mixed, and Trading rule results have been mixed, and most have not been able to beat a buy-most have not been able to beat a buy-and-hold policyand-hold policy


Problems with testsProblems with tests• Cannot be definitive since trading rules can Cannot be definitive since trading rules can

be complex and there are too many to test be complex and there are too many to test them allthem all

• Testing constraintsTesting constraints– Use only publicly available dataUse only publicly available data– Should include all transactions costsShould include all transactions costs– Should adjust the results for risk (an apparently Should adjust the results for risk (an apparently

successful strategy may just be a very risky successful strategy may just be a very risky strategy)strategy)

Conclusions: Conclusions: Weak-Form EMHWeak-Form EMH

• Results generally support the weak-Results generally support the weak-form EMH, but results are not form EMH, but results are not unanimousunanimous– Some strategies too subjective to testSome strategies too subjective to test– Not all trading rules are disclosedNot all trading rules are disclosed

• If you had a trading strategy that worked, If you had a trading strategy that worked, would you reveal it?!would you reveal it?!

Reality Check!Reality Check!

• If someone writes a If someone writes a book on how to “beat book on how to “beat the market,” you can the market,” you can bet that book sales are bet that book sales are more lucrative than the more lucrative than the trading strategy!trading strategy!

• Even if it once worked, Even if it once worked, if it’s widely known, it if it’s widely known, it won’t work any more!won’t work any more!

• Don’t quit your day job Don’t quit your day job to trade on-line using a to trade on-line using a published strategy!published strategy!

Tests and Results: Tests and Results: Semistrong-Form EMHSemistrong-Form EMH

Three different groups of tests:Three different groups of tests:• Time series analysis using public informationTime series analysis using public information• Event studies examine how fast stock prices Event studies examine how fast stock prices

adjust to significant economic eventsadjust to significant economic events• Cross-sectional analysis of returns based on Cross-sectional analysis of returns based on

public informationpublic informationTests involve the estimation of “abnormal Tests involve the estimation of “abnormal

returns,” where expected abnormal returns returns,” where expected abnormal returns are zero in an efficient market.are zero in an efficient market.

Tests and Results:Tests and Results:Semistrong-Form EMHSemistrong-Form EMH

• Tests often involve “market-adjusted returns,” Tests often involve “market-adjusted returns,” created by subtracting the market return from created by subtracting the market return from the security’s return, thereby defining a the security’s return, thereby defining a security’s “abnormal return:” security’s “abnormal return:”

ARARitit = R = Ritit - R - Rmtmt

where:where:

– ARARitit = abnormal return on security i during period t = abnormal return on security i during period t

– RRitit = return on security i during period t = return on security i during period t

– RRmtmt = return on a market index during period t = return on a market index during period t

Tests and Results ofTests and Results ofSemistrong-Form EMHSemistrong-Form EMH

• Another definition of abnormal return is a “risk-Another definition of abnormal return is a “risk-adjusted return” or “market model” which adjusted return” or “market model” which adjusts for the security’s own required rate of adjusts for the security’s own required rate of return, given its systematic risk (as measured return, given its systematic risk (as measured by beta):by beta):

ARARitit = R = Ritit - E(R - E(Ritit))where: where: – E(RE(Ritit) = the expected rate of return for stock i during ) = the expected rate of return for stock i during

period t based on the market rate of return and the period t based on the market rate of return and the stock’s normal relationship with the market (its beta)stock’s normal relationship with the market (its beta)


Time series tests for predictability of returns Time series tests for predictability of returns and profit opportunitiesand profit opportunities

• Short-horizon returns have shown very Short-horizon returns have shown very limited predictabilitylimited predictability

• Long-horizon returns analysis shown some Long-horizon returns analysis shown some predictability of returns based on:predictability of returns based on:– Dividend yield (D/P)Dividend yield (D/P)– Default spreadDefault spread– Term structure spreadTerm structure spread


Time series tests for predictability of returns Time series tests for predictability of returns and profit opportunitiesand profit opportunities

• Quarterly earnings reports informationQuarterly earnings reports information– Unanticipated earnings changes or “earnings Unanticipated earnings changes or “earnings

surprises” are not immediately reflected in security surprises” are not immediately reflected in security pricesprices

• The January Anomaly (A “calendar” effect)The January Anomaly (A “calendar” effect)– Large returns in January present opportunities to Large returns in January present opportunities to

purchase in December, and sell in January and purchase in December, and sell in January and earn abnormal returns.earn abnormal returns.


Time series tests for predictability of Time series tests for predictability of returns and profit opportunitiesreturns and profit opportunities

• Other calendar effectsOther calendar effects– Monthly effectMonthly effect– Day-of-the-week effectsDay-of-the-week effects

• Monday returns were significantly negativeMonday returns were significantly negative


Predicting cross-sectional returnsPredicting cross-sectional returns• In an efficient market, all securities should In an efficient market, all securities should

have equal risk-adjusted returnshave equal risk-adjusted returns• Studies examine alternative measures of size Studies examine alternative measures of size

or quality as a tool to rank stocks in terms of or quality as a tool to rank stocks in terms of risk-adjusted returnsrisk-adjusted returns– These tests include a joint hypothesis of both These tests include a joint hypothesis of both

market efficiency and the asset pricing model market efficiency and the asset pricing model used to generate abnormal returnsused to generate abnormal returns


Predicting cross-sectional returnsPredicting cross-sectional returns• Price-earnings ratiosPrice-earnings ratios

– Examine historical P/E ratios and returnsExamine historical P/E ratios and returns– Low P/E stocks had higher risk-adjusted returns Low P/E stocks had higher risk-adjusted returns

than high P/E stocksthan high P/E stocks– Publicly available P/E ratios could be used for Publicly available P/E ratios could be used for

abnormal returnsabnormal returns

• Price-earnings/Growth ratiosPrice-earnings/Growth ratios– Mixed resultsMixed results


Predicting cross-sectional returnsPredicting cross-sectional returns• The size effectThe size effect

– The risk-adjusted returns for extended periods The risk-adjusted returns for extended periods indicate that the small firms consistently indicate that the small firms consistently experienced significantly larger risk-adjusted experienced significantly larger risk-adjusted returns than large firmsreturns than large firms

– Abnormal returns could occur because either Abnormal returns could occur because either markets are inefficient or the market model is not markets are inefficient or the market model is not properly specified and provides incorrect properly specified and provides incorrect estimates of risk and expected returns (joint test)estimates of risk and expected returns (joint test)


Predicting cross-sectional returnsPredicting cross-sectional returns• The size effectThe size effect

– Adjustments for riskiness of small firms did not Adjustments for riskiness of small firms did not explain the large differences in rate of returnexplain the large differences in rate of return

– The impact of transactions costs of investing in The impact of transactions costs of investing in small firms is substantial (takes away the small firms is substantial (takes away the differential with a short-term trading strategy)differential with a short-term trading strategy)

– Even after risk and transaction costs, small firms Even after risk and transaction costs, small firms outperform large firms with annual tradingoutperform large firms with annual trading

– The small-firm effect is not stableThe small-firm effect is not stable– Firm size is an important anomalyFirm size is an important anomaly


Predicting cross-sectional returnsPredicting cross-sectional returns

• Neglected firms and trading activityNeglected firms and trading activity– Is there an effect related to the number of Is there an effect related to the number of

analysts following a stock and how analysts following a stock and how frequently a stock trades?frequently a stock trades?

– Mixed results, mostly any apparent effects Mixed results, mostly any apparent effects explained by taking the size effect into explained by taking the size effect into considerationconsideration


Predicting cross-sectional returnsPredicting cross-sectional returns• Book value-market value (BV/MV) ratioBook value-market value (BV/MV) ratio

– Significant positive relationship between the Significant positive relationship between the current values for this ratio and future stock current values for this ratio and future stock returnsreturns

• Although various measures including the P/E Although various measures including the P/E ratio seem to help predict future returns, the ratio seem to help predict future returns, the size effect and BV/MV ratio have the greatest size effect and BV/MV ratio have the greatest predictive ability.predictive ability.


Event studiesEvent studies• Event studies examine abnormal returns Event studies examine abnormal returns

surrounding various eventssurrounding various events• The EMH is that abnormal returns are zeroThe EMH is that abnormal returns are zero• Stock split studies Stock split studies

– Mostly show no positive impact on returns Mostly show no positive impact on returns because of a stock splitbecause of a stock split

• Initial public offerings Initial public offerings – Significant IPO underpricing, but with rapid Significant IPO underpricing, but with rapid

adjustment, consistent with the EMHadjustment, consistent with the EMH


Event studies Event studies • Exchange listingsExchange listings

– Some evidence of short-term profit Some evidence of short-term profit potential following the “listing potential following the “listing announcement”announcement”

• Unexpected world events and economic Unexpected world events and economic news news – Quickly reflected in security prices, do not Quickly reflected in security prices, do not

provide opportunitiesprovide opportunities


Event StudiesEvent Studies• Announcements of accounting changes Announcements of accounting changes

– Quickly reflect in security prices and do not seem Quickly reflect in security prices and do not seem to provide abnormal profit opportunitiesto provide abnormal profit opportunities

• Corporate events Corporate events – Prices react quickly to announcements of Prices react quickly to announcements of

mergers, financing decisions, etc.mergers, financing decisions, etc.– No systematic profit opportunitiesNo systematic profit opportunities

Summary on the Summary on the Semistrong-Form EMHSemistrong-Form EMH

• Evidence is mixedEvidence is mixed• Strong support of the EMH from numerous Strong support of the EMH from numerous

event studies with the exception of exchange event studies with the exception of exchange listing studieslisting studies

• Strong evidence against the EMH from both Strong evidence against the EMH from both time series and cross-sectional studies time series and cross-sectional studies – Dividend yields, earnings surprises, calendar Dividend yields, earnings surprises, calendar

effectseffects– The size effect, BV/MV, P/E ratios, etc.The size effect, BV/MV, P/E ratios, etc.

Tests and Results: Strong-Tests and Results: Strong-Form EMHForm EMH

Testing Groups of InvestorsTesting Groups of Investors• Tests usually center on whether any Tests usually center on whether any

group of investors consistently earn group of investors consistently earn abnormal profits.abnormal profits.– Corporate insidersCorporate insiders– Stock exchange specialistsStock exchange specialists– Security analystsSecurity analysts– Professional money managersProfessional money managers


Corporate InsidersCorporate Insiders• Insiders include major corporate officers, Insiders include major corporate officers,

directors, and owners of 10% or more of any directors, and owners of 10% or more of any equity class of securitiesequity class of securities

• Insiders must report to the SEC each month Insiders must report to the SEC each month on their transactions as insiderson their transactions as insiders

• These insider trades are made public about These insider trades are made public about six weeks later and allow for studysix weeks later and allow for study


Corporate InsidersCorporate Insiders• Mixed resultsMixed results• Corporate insiders generally experience above-Corporate insiders generally experience above-

average profits especially on purchase average profits especially on purchase transactionstransactions– This implies that many insiders had private This implies that many insiders had private

information from which they derived above-average information from which they derived above-average returns on their company stockreturns on their company stock

• Later studies indicate that non-insiders who Later studies indicate that non-insiders who trade with insiders may no longer be able to trade with insiders may no longer be able to generate abnormal returnsgenerate abnormal returns


Stock Exchange SpecialistsStock Exchange Specialists

• Specialists have monopolistic access to Specialists have monopolistic access to information about unfilled limit ordersinformation about unfilled limit orders

• You would expect specialists to derive You would expect specialists to derive above-average returns because of their above-average returns because of their superior information, and this appears superior information, and this appears to be the case.to be the case.


Security AnalystsSecurity Analysts• Tests have considered whether it is possible Tests have considered whether it is possible

to identify a set of analysts who have the to identify a set of analysts who have the ability to select undervalued stocksability to select undervalued stocks

• This looks at whether, after a stock selection This looks at whether, after a stock selection by an analyst is made known, a significant by an analyst is made known, a significant abnormal return is available to those who abnormal return is available to those who follow their recommendationfollow their recommendation


Security AnalystsSecurity Analysts• The Value Line EnigmaThe Value Line Enigma

– Firms ranked 1 for “timeliness” substantially Firms ranked 1 for “timeliness” substantially outperform the market; firms ranked 5 substantially outperform the market; firms ranked 5 substantially underperform the market underperform the market

– Prices now adjust quickly to changes in rankingsPrices now adjust quickly to changes in rankings– Net of transaction costs, rankings do not appear to Net of transaction costs, rankings do not appear to

have value in terms of producing abnormal returnshave value in terms of producing abnormal returns

• There is some evidence of superior analysts There is some evidence of superior analysts who apparently posses private informationwho apparently posses private information


Professional Money ManagersProfessional Money Managers• Trained professionals, working full time at Trained professionals, working full time at

investment managementinvestment management• If any investor can achieve above-average If any investor can achieve above-average

returns, it should be this groupreturns, it should be this group• If any non-insider can obtain inside If any non-insider can obtain inside

information, it would be this group due to the information, it would be this group due to the extensive management interviews that they extensive management interviews that they conductconduct


Professional Money ManagersProfessional Money Managers

• Most tests examine mutual fundsMost tests examine mutual funds

• Risk-adjusted returns of mutual funds Risk-adjusted returns of mutual funds generally show that most funds did not generally show that most funds did not match aggregate market performancematch aggregate market performance

Summary on the Summary on the Strong-Form EMHStrong-Form EMH

• Mixed resultsMixed results• Some strong supportSome strong support

– Professional money managersProfessional money managers

• Some strong evidence against the EMHSome strong evidence against the EMH– Tests for corporate insiders and stock exchange Tests for corporate insiders and stock exchange

specialists do not support the hypothesis specialists do not support the hypothesis • Both groups seem to have monopolistic access to Both groups seem to have monopolistic access to

important information and use it to derive above-average important information and use it to derive above-average returnsreturns

Behavioral FinanceBehavioral Finance

• A growing field of study in finance.A growing field of study in finance.• Rather than assuming ultra-rational behavior, Rather than assuming ultra-rational behavior,

the area of behavioral finance seeks to the area of behavioral finance seeks to incorporate how humans actually behave.incorporate how humans actually behave.– Incorporates the ways in which psychology may Incorporates the ways in which psychology may

impact investment decisionsimpact investment decisions– It has been useful for explaining various It has been useful for explaining various

“anomalies” that we observe in decision-making “anomalies” that we observe in decision-making that are difficult to reconcile with rationalitythat are difficult to reconcile with rationality

Behavioral FinanceBehavioral Finance

Using psychological biases to explain behaviorUsing psychological biases to explain behavior– Why do investors persistently “ride” losers and sell Why do investors persistently “ride” losers and sell

winners?winners?• Can be explained by prospect theoryCan be explained by prospect theory

– Why do investors display overconfidence in Why do investors display overconfidence in forecasts?forecasts?

• Can be explained by the confirmation biasCan be explained by the confirmation bias

– Why do investors tend to put more money into Why do investors tend to put more money into failing investments?failing investments?

• Can be explained by the escalation biasCan be explained by the escalation bias

Fusion InvestingFusion Investing

• Attempts to integrate two elements of Attempts to integrate two elements of investment valuation:investment valuation:– Fundamental valueFundamental value

• Dominant factorDominant factor

– Investor sentimentInvestor sentiment• Additional demand factor related to fads and Additional demand factor related to fads and

fashionsfashions

Implications of Market Implications of Market EfficiencyEfficiency

• Overall results indicate the capital markets Overall results indicate the capital markets are efficient as related to numerous sets of are efficient as related to numerous sets of informationinformation

• There are substantial instances where the There are substantial instances where the market fails to rapidly adjust to public market fails to rapidly adjust to public informationinformation– So, what techniques will or won’t work?So, what techniques will or won’t work?– What do you do if you can’t beat the market?What do you do if you can’t beat the market?

Efficient Markets Efficient Markets and Technical Analysisand Technical Analysis

• Assumptions of technical analysis directly Assumptions of technical analysis directly oppose the notion of efficient marketsoppose the notion of efficient markets

• Technicians believe that stock prices move in Technicians believe that stock prices move in patterns that persist and are predictable to patterns that persist and are predictable to the informed investor.the informed investor.

• Technical analysts develop systems to detect Technical analysts develop systems to detect trends and patterns in pricestrends and patterns in prices

• If the capital market is weak-form efficient, a If the capital market is weak-form efficient, a trading system that depends on past trading trading system that depends on past trading data can have no valuedata can have no value

Efficient Markets and Efficient Markets and Fundamental AnalysisFundamental Analysis

• Fundamental analysis involves determining Fundamental analysis involves determining an investment’s intrinsic values based on an investment’s intrinsic values based on company and economic “fundamentals”company and economic “fundamentals”– The intrinsic value is compared to the market The intrinsic value is compared to the market

price to determine whether the investment is price to determine whether the investment is undervalued or overvaluedundervalued or overvalued

• In an efficient market, prices already reflect In an efficient market, prices already reflect public information, so determining “intrinsic public information, so determining “intrinsic value” using that information is not a value” using that information is not a worthwhile exerciseworthwhile exercise

Efficient Markets and Efficient Markets and Fundamental AnalysisFundamental Analysis

• Past vs. FuturePast vs. Future– The EMH, importantly, considers the incorporation The EMH, importantly, considers the incorporation

of available information, which is primarily historic of available information, which is primarily historic in nature.in nature.

– Much of what is involved in fundamental analysis, Much of what is involved in fundamental analysis, including aggregate market analysis and industry including aggregate market analysis and industry analysis, involves estimating future values.analysis, involves estimating future values.

– Superior analysts are those who will be better at Superior analysts are those who will be better at predicting this uncertain future.predicting this uncertain future.

Efficient Markets and Efficient Markets and Portfolio ManagementPortfolio Management

• Does active portfolio management pay Does active portfolio management pay off?off?– Research indicates that most money Research indicates that most money

managers do keep pace with the marketmanagers do keep pace with the market

• Certainly with a superior analyst, Certainly with a superior analyst, recommendations should be followedrecommendations should be followed– Opportunities may be present in smaller, Opportunities may be present in smaller,

neglected stocks (although risk must be neglected stocks (although risk must be taken into account)taken into account)

Efficient Markets and Efficient Markets and Portfolio ManagementPortfolio Management

• Without superior analysts, passive Without superior analysts, passive management may outperform active management may outperform active management management – Build a globally diversified portfolio with a Build a globally diversified portfolio with a

risk level matching client preferencesrisk level matching client preferences– Minimize transaction costs (taxes, trading Minimize transaction costs (taxes, trading

turnover, liquidity costs)turnover, liquidity costs)

The Rationale and The Rationale and Use of Index FundsUse of Index Funds

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

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

Insights from Behavioral Insights from Behavioral FinanceFinance

• There may be trading opportunities There may be trading opportunities created by persistent investor biases created by persistent investor biases and “herd mentality”and “herd mentality”– Supports the notion of contrarian Supports the notion of contrarian

investment strategiesinvestment strategies– Some mutual funds employ behavioral Some mutual funds employ behavioral

finance strategiesfinance strategies

Efficiency in European Efficiency in European Equity MarketsEquity Markets

• Hawawini study indicates behavior of Hawawini study indicates behavior of European stock prices is similar to U.S. European stock prices is similar to U.S. common stockscommon stocks– Despite market differences, most results Despite market differences, most results

are essentially similarare essentially similar– Appropriate to assume a similar level of Appropriate to assume a similar level of

efficiency in European markets to those in efficiency in European markets to those in the United Statesthe United States

Documents

Chapter 10 EFFICIENT CAPITAL MARKETS. Chapter 10 Questions What do we mean when we say that capital markets are efficient?What do we mean when we say