Are Market Efficient?

The Issues

Magnitude Issue

 Efficiency is relative, not binary.

 The magnitude issue simply implies that only managers of large portfolios can benefit

from finding minor discrepancies in the market.

 The minor discrepancies are too small to measure.

Selection Bias Issue

 Investors who find successful investment schemes are less inclined to share findings.

 Observable outcomes preselected in favor of failed attempts

 Two Choices

◦ Publish your technique in the Wall Street Journal to win fleeting fame

◦ Keep your technique secret and use it to earn millions of dollars

Lucky Event Issue

 Lucky investments receive disproportionate attention

 Any bet on a stock is simply a coin toss

 Lucky (doubter) vs Skill (investor)

Weak-Form Tests

A. Returns over Short Horizon

◦ The investor tends to have a low risk tolerance and should invest in guaranteed

securities, such as certificates of deposit or high-interest savings accounts

◦ Serial Correlation

◦ Refers to the tendency for stock return to be related to past

returns

◦ Positive: Positive returns tend to follow

positive return

◦ Negative: Positive returns tend to follow

negative return

◦ Momentum effect: Tendency of poorly or

well-performing stocks to continue abnormal

performance in following periods

B. Returns over Long Horizon

 Investors typically include a higher percentage of risky investments. It is essential

to consider that equities can go through prolonged periods of very little growth.

 reversal effect: tendency of poorly or well performing stocks to experience

reversals in following periods

Predictors of Broad Market Returns

 Fama and French

◦ Aggregate returns are higher with higher dividend ratios

 Campbell and Shiller

◦ Earnings yield can predict market returns

 Keim and Stambaugh

◦ Bond spreads can predict market returns