CH9&10 Market Efficiency and Behavioral Finance.pdf

CH9&10 Market Efficiency and Behavioral Finance.pdf -...

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Market Efficiency Relates to Ch. 9 of Bodie
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Defining the concept of efficiency 2 In this context we mean informational efficiency. An efficient capital market is one in which the prices fully and instantaneously reflect all available relevant information. The contention that current prices reflect all available information is referred to as the Efficient Market Hypothesis (EMH). You sometimes hear that an efficient market means prices follow a random walk . That is, they move around in a random, unpredictable fashion. Investment Principles: James Shou
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The big question: Are capital markets efficient? 3 We’re not sure. And we’ll never be sure. Proving the EMH is like proving the existence of a deity. You have evidence for and against. It is forever a muddle. Regardless, efficiency is a matter of degree. Investment Principles: James Shou
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Price reactions around CNBC news items 4 Investment Principles: James Shou
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Degrees of the EMH (due to Fama) 5 Weak-form: You can’t earn excess returns by developing trading rules based on past price or return information. In other words, studying charts is a waste of time. Semistrong-form: You can’t earn excess returns from publicly available information. In other words, studying annual reports, reading newspapers/newsletters, etc. is a waste of time. Here, security analysis is useless. Strong-form: No investor can earn excess returns using any information, be it publicly available or not. Here, even inside information doesn’t help. Investment Principles: James Shou
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A few thoughts on EMH 6 EMH does NOT mean a randomly selected portfolio is as good as any other. There’s no control for risk here; however, if one identifies a pool of assets with similar risk, then random selection is as good as anything. Also, there are tax considerations, etc EMH doesn’t mean you can’t make money in the market. It means you can only expect to achieve the market- determined expected return and nothing more EMH doesn’t imply no price fluctuations. On the contrary, it implies fluctuations due to news, which by definition, is random. Investment Principles: James Shou
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Implications of EMH…if you believe it… 7 Don’t waste your time with security selection. Buy and hold a broad portfolio (e.g. index funds). If you expend resources you will generate a lot of costs with no expected payoff. Investment Principles: James Shou
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Evidence for the EMH 8 A TON of testing of this hypothesis has been done…Evidence is somewhat supportive of weak and semistrong forms of EMH, not supportive of strong form And yet…there is some evidence of… Predictability of returns over long horizons (e.g. earnings yield, sell winners/buy dogs) Momentum strategies seem to have some merit There are (or have been) anomalies in the market (e.g. January effect, small-firm effect) There are others Investment Principles: James Shou
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EMH: The joint hypothesis problem 9 To know if a return pattern is abnormal, you must have an idea of what a normal return pattern is.
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