Markets chapter 12 Jones Efficient Markets How well do markets respond to new information Should it be possible to decide between a profitable and unprofitable investment given current information ID: 586983
Download Presentation The PPT/PDF document "The Efficient Capital" is the property of its rightful owner. Permission is granted to download and print the materials on this web site for personal, non-commercial use only, and to display it on your personal computer provided you do not modify the materials and that you retain all copyright notices contained in the materials. By downloading content from our website, you accept the terms of this agreement.
Slide1
The Efficient Capital
Markets(chapter 12 Jones)Slide2
Efficient Markets
How well do markets respond to new information?
Should it be possible to decide between a profitable and unprofitable investment given current information?
Efficient Markets
The prices of all securities quickly and fully reflect all available informationSlide3
Conditions for an Efficient Market
Large number of rational, profit-maximizing investors
Actively participate in the market
Individuals cannot affect market prices
Information is costless, widely available, generated in a random fashion
Investors react quickly and fully to new informationSlide4
Consequences of Efficient Market
Quick price adjustment in response to the arrival of random information makes the reward for analysis low
Prices reflect all available information
Price changes are independent of one another and move in a random fashion
New information is independent of pastSlide5
Alternative Efficient Market Hypotheses
The various forms of the efficient market hypothesis differ in terms of the information that security prices should reflect.
Weak-form EMH
Semistrong-form EMH
Strong-form EMHSlide6
Weak-Form EMH
Current prices fully reflect all security-market information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information
This implies that past rates of return and other market data should have no relationship with future rates of return
Implication:
Examining recent trends in price and other market data (called Technical analysis) in order to predict future price changes would be a waste of time if the market is weak-form efficientSlide7
Tests and Results: Weak-Form EMH
Problems with tests
Cannot be definitive since trading rules can be complex and there are too many to test them all
Testing constraints
Use only publicly available data
Should include all transactions costs
Should adjust the results for risk (an apparently successful strategy may just be a very risky strategy)
If someone writes a book on how to “beat the market,” you can bet that book sales are more lucrative than the trading strategy!
Even if it once worked, if it’s widely known, it won’t work any more!Slide8
Semistrong-Form EMH
Current security prices reflect all public information, including market and non-market information
This implies that decisions made on new information after it is public should not lead to above-average risk-adjusted profits from those transactions
Implication:
If the market is efficient in this sense, information in
The Wall Street Journal
, other periodicals, and even company annual reports is already fully reflected in prices, and therefore not useful for predicting future price changes.Slide9
Strong-Form EMH
Stock prices fully reflect all information from public and private sources
Implication:
Not even “insiders” would be able to “beat the market” on a consistent basis
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.Slide10
Anomalies
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.The neglected firm effect :
Neglected firms seem to offer superior returns with surprising regularitySlide11
Anomalies
Market Overreaction and Momentum
: It is observed that the market tends to overreact to extreme news. So, systematic price reversals can sometimes be predicted.
Security Analysts
This looks at whether, after a stock selection by an analyst is made known, a significant abnormal return is available to those who follow their recommendation
There is some evidence of superior analysts, and as a group the stocks with better analysts ratings have better returns
The Value Line Enigma
Advisory service that ranks 1700 stocks from best (1) to worst (5)
Probable price performance in next 12 months
1980-1993, Group 1 stocks had annualized return of 19.3%
Best investment letter performance overallSlide12
Other Tests and Results
Professional Money Managers
If any investor can achieve above-average returns, it should be this group
If any non-insider can obtain inside information, it would be this group due to the extensive management interviews that they conduct
Risk-adjusted returns of mutual funds generally show that most funds did not match aggregate market performanceSlide13
The Rationale and Use of Index Funds
(passive investing)
Efficient capital markets and a lack of superior analysts imply that many portfolios should be managed passively (so their performance matches the aggregate market, minimizes the costs of research and trading)
Institutions created market (index) funds which duplicate the composition and performance of a selected index seriesSlide14
Behavioral
FinanceSlide15
Behavioral Finance vs Standard Finance
Behavioral finance considers how various psychological traits
affect investors
Behavioral finance recognizes that the standard finance model of
rational behavior can be true within specific boundaries but argues
that this model is incomplete since it does not consider the individual
behavior.
Currently there is no unified theory of behavioral finance, thus the
emphasis has been on identifying investment anomalies that can be
explained by various psychological traits.Slide16
Loss Aversion and Mental Accounting
First decision
: Choose between
Choice 1: sure gain of $ 85,000
Choice 2: 85% chance of receiving $100,000 and 15%
chance of receiving nothing
Second decision
: Choose between
Choice 1: sure loss of $ 85,000
Choice 2: 85% chance of losing $100,000 and 15%
chance of losing nothingSlide17
Mental Accounting
Individuals tend to keep a
mental account
for each investment option,
instead of looking at the investment decisions as a “package”
Many investors are highly risk averse with money in some
accounts and risk lovers with money in other accountsSlide18
Mental Accounting: sunk costs
You have a ticket to a Dodgers game, ticket worth $60. On the day of the game there is a big rain. Although you can still go to the game and the game is playing, the rain will reduce the pleasure of watching the game. Are you more likely to go to the game if you purchased the ticket or if the ticket was given to you for free?Slide19
Seeking pride and avoiding regret
Rational individuals feel no greater disappointment when they
miss their plane by a minute as when they miss it by an hour.
What about most of us?
Most of the investors sell winners too early, riding losers too
long (called the disposition effect)
Individuals who make decisions that turn out badly have more regret
when that decisions were more unconventional