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Chapter 10:Market Efficiency and

Behavioral Finance

Corporate Finance, 3eGraham, Smart, and Megginson

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Efficient Financial Markets

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Informational efficiency The efficient markets hypothesis (EMH)

asserts that financial asset prices fully reflect all available information.

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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.

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Forms of Market EfficiencySemistrong-form efficiency

Asset prices incorporate all publicly available information

The level of asset prices should correctly reflect all pertinent historical, current, and predictable future information obtainable from public sources.

Asset prices should change fully and instantaneously in response to relevant new information.

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Semistrong-Form Efficiency and Fundamental Analysis Recall the definition of efficient markets: In an efficient

market, prices rapidly incorporate all relevant information.

Semi-strong form efficiency uses “all public information” as its definition of “information.”

Prices move so fast in response to public information that trading on it profitably is nearly impossible!

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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.

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Empirical Evidence on Market Efficiency

Tests for return predictabilityTests of simple trading rules Tests of the effectiveness of technical analysis Tests for return continuations or reversalsTests of the performance of newly issued

sharesHigh initial IPO returns followed by subpar longer-

term performance

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Tests for Rapid Price Adjustment

Event studyEvent 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.

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Tests for Private Information

Tests of the Profitability of Insider Trading

Tests of Mutual Fund Investment Performance

Selectivity Timing

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Tests for Private Information

Tests of Pension Fund and Hedge Fund Investment Performance

Tests of the Stock-Picking Abilities of Security Analysts

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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.

The Behavioral Finance Critiqueof Market Efficiency

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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.

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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.

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-5 -4 -3 -2 -1 0 +1 +2 +3 +4 +5 Time (months)

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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.

Stock Price Momentum

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.

The Underreaction Phenomenon

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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.

-5 -4 -3 -2 -1 0 +1 +2 +3 +4 +5 Time (years)

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Stock Price Momentum

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.

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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.

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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.

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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?

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Communication StrategyHow 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.