Practice investment management pim3 ch10

 The Efficient Market Hypothesis  Types of Efficiency  Degrees of Informational Efficiency  The Semi-Efficient Market Hypothesis  Security Prices and Random Walks... The Efficient M

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MARKET EFFICIENCY

CHAPTER TEN

Practical Investment Management

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 The Efficient Market Hypothesis

 Types of Efficiency

 Degrees of Informational Efficiency

 The Semi-Efficient Market Hypothesis

 Security Prices and Random Walks

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 Anomalies

 The Low PE Effect

 Low-Priced Stocks

 The Small Firm and Neglected Firm Effects

 Market Overreaction

 The January Effect

 The Weekend Effect

 The Persistence of Technical Analysis

 Final Thoughts

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The Efficient Market Hypothesis

 Operational efficiency is a measure of how

well things function in terms of speed of

execution and accuracy.

 Informational efficiency is a measure of how

quickly and accurately the market reacts to new information.

 The efficient market hypothesis (EMH) deals Types of Efficiency

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ASSUMPTIONS:

1 Investors are rational and value securities in a

rational manner.

2 To the extent investors are not rational, they trade

randomly, so irrationalities tend to cancel each other out.

3 To the extent that investors are not randomly

irrational, they are met in the marketplace by rational arbitrageurs, who eliminate any remaining irrational pricing elements.

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The EMH: Degrees of Informational Efficiency

Weak Form Efficiency

 This least restrictive form of the

EMH states that future stock prices cannot be predicted by analyzing prices from the past.

 In other words, the current stock price fully

reflects any information contained in the

past series of stock prices.

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Insert Figure 10-1 here.

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Insert Figure 10-2 here.

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 An autocorrelation test investigates whether

security returns are related through time A

runs test, for example, measures the

likelihood that a series of two variables is a random occurrence.

 A filter rule is a trading rule regarding the

actions to be taken when shares rise or fall in

value by x% Filter rules should not

work if markets are weak form efficient.

Tests of Weak Form Efficiency autocorrelation tests filter rule tests

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Tests of Weak Form Efficiency

Insert Table 10-3 here.

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Tests of Weak Form Efficiency

Insert Table 10-4 here.

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Semistrong Form Efficiency

 Event studies involving phenomena

occurring at known points in time, such as a stock split or the announcement of corporate earnings, are frequently used in tests of the

 Semistrong form efficiency states

that security prices reflect all publicly available information.

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Strong Form Efficiency

 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.

 This most extreme version of the

EMH states that security prices fully reflect all relevant public and private information.

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 The essence of the semi-efficient market

hypothesis is the notion that some stocks are priced more efficiently than others This idea is sometimes used in support of the

thesis that the market has several tiers.

 The random walk idea states that

news arrives randomly, not that stock prices move randomly.

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 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.

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 The neglected firm effect : Neglected firms

seem to offer superior returns with

surprising regularity.

 Market Overreaction : It is observed that

the market tends to overreact to extreme

news So, systematic price reversals can

sometimes be predicted.

 The January effect : In January, stock returns

are inexplicably high, and small firms’ stocks

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 The weekend effect : It is observed that

security price changes tend to be negative on Mondays and positive on the other days of

the week, with Friday being the best of all.

 The persistence of technical analysis : If the EMH is true, technical analysis should be

useless Each year however, an immense

amount of literature based in varying degrees

on the subject is printed.

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From the individual investor’s perspective, the

US capital markets are informationally and

operationally quite efficient Still, much is not yet known about asset pricing, resulting in a fair, but complicated financial battleground.

Final thoughts

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