The The Efficient Market Market HypothesisHypothesis

9-9-22Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 1998

Efficient Market Hypothesis (EMH)

• Do security prices reflect information ?

• Why look at market efficiency – Implications for business and

corporate finance– Implications for investment

9-9-33Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 1998

Forms of the EMH

• Weak

• Semi-strong

• Strong

9-9-44Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 1998

Types of Stock Analysis

• Technical Analysis - using prices and volume information to predict future prices– Weak form efficiency & technical analysis

• Fundamental Analysis - using economic and accounting information to predict stock prices– Semi strong form efficiency & fundamental

analysis

9-9-55Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 1998

• Why are price changes random?– Prices react to information– Flow of information is random– Therefore, price changes are random

Random Walk Hypothesis

Security Security PricesPrices

TimeTimeIrwin/McGraw-Hill

©The McGraw-Hill Companies, Inc., 1998

9-49-4

Random Walk with Positive TrendRandom Walk with Positive Trend

9-9-77Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 1998

• Event studies

• Assessing performance of professional managers

• Testing some trading rule

Empirical Tests of Market EfficiencyEmpirical Tests of Market Efficiency

00 +t+t-t-t

Announcement DateAnnouncement Date

Irwin/McGraw-Hill

©The McGraw-Hill Companies, Inc., 1998

9-139-13

Returns Over TimeReturns Over Time

9-9-99Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 1998

• Technical Analysis

• Fundamental Analysis

• Anomalies Exist

What Does the Evidence Show?

9-9-1010Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 1998

• Small Firm Effect (January Effect)Small Firm Effect (January Effect)

• Neglected FirmNeglected Firm

• Market to Book RatiosMarket to Book Ratios

• ReversalsReversals

• Value Line EnigmaValue Line Enigma

• Post-Earnings Announcement DriftPost-Earnings Announcement Drift

• Higher Level Correlation in Security Higher Level Correlation in Security PricesPrices

Anomalies

9-9-1111Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 1998

Mutual Fund and Professional Mutual Fund and Professional Manager PerformanceManager Performance

• Some evidence of persistent positive and negative performance

• Potential measurement error for benchmark returns

–Style changes

–May be risk premiums

• Superstar phenomenon

9-9-1212Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 1998

• Active ManagementActive Management– Security analysisSecurity analysis– TimingTiming

• Passive ManagementPassive Management– Buy and HoldBuy and Hold– Index FundsIndex Funds

Implications of Efficiency for Active or Passive Management

9-9-1313Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 1998

Even if the market is efficient a role exists for portfolio management

–Appropriate risk level

–Tax considerations

–Other considerations

Market Efficiency and Portfolio Management