Random Walks and Efficient Markets

• Random Walk: the theory that stock price

movements are unpredictable, so there is
no way to know where prices are headed
– Studies of stock price movements indicate that
they do not move in neat patterns
– This random pattern is a natural outcome of
markets that are highly efficient and respond
quickly to changes in material information
– Definition of random walk: The best prediction
of the future price is today’s price.

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 Random Walks
and Efficient Markets (cont’ d)

• Efficient Market: a market in which securities

reflect all possible information quickly and
accurately
• To have an efficient market, you must have:
– Many knowledgeable investors actively analyzing and
trading stocks
– Information is widely available to all investors
– Events, such as labor strikes or accidents, tend to happen
randomly
– Investors react quickly and accurately to new information

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 Efficient Market Hypothesis

• Efficient Market Hypothesis (EMH):

information is reflected in prices—not only the type
and source of information, but also the quality and
speed with which it is reflected in prices. The more
information that is incorporated into prices, the
more efficient the market becomes.
• Levels of the EMH
– Weak Form EMH
– Semi-strong Form EMH
– Strong Form EMH

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 Levels of EMH

• Weak Form EMH

– Past data on stock prices are of no use in predicting future
stock price changes
– Everything is random
– Should simply use a “buy-and-hold” strategy
• Semi-strong Form EMH
– Abnormally large profits cannot be consistently earned
using public information
– Any price anomalies are quickly found out and the stock
market adjusts
• Strong Form EMH
– There is no information, public or private, that allows
investors to consistently earn abnormally high returns

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 Market Anomalies

• Calendar Effects
– Stocks returns may be closely tied to the time of
year or time of week
– Questionable if really provide opportunity
– Examples: January effect, weekend effect

• Small-Firm Effect
– Size of a firm impacts stock returns
– Small firms may offer higher returns than larger
firms, even after adjusting for risk
– (market impact of trading?)

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 Market Anomalies (cont’ d)

• Post Earnings Announcement Drift

(Momentum)
– Stock price adjustments may continue after
earnings adjustments have been announced
– Unusually good quarterly earnings reports may
signal buying opportunity

• Value Effect
– Uses P/E ratio to value stocks
– Low P/E stocks may outperform high P/E stocks,
even after adjusting for risk

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 Possible Explanations

• Stocks that appear to earn abnormally

returns are actually riskier, so higher
returns merely represent compensation for
risk
• Some anomalies may simply be patterns in
that data that appeared by chance and are
thus not likely to persist over time
• Behavioral biases may cause investors to
make systematic mistakes when they
invest, and those mistakes create
inefficiencies in the market
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 Investor Behavior and Security
Prices

• Overconfidence
– Investors tend to be overconfident in their judgment,
leading them to underestimate risks

• Self-Attribution Bias
– Investors tend to take credit for successes and blame
others for failures
– Investors will follow information that supports their beliefs
and disregard conflicting information
• These biases may cause investors to trade too
often

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 Investor Behavior
and Security Prices (cont’ d)

• Loss Aversion
– Investors dislike losses much more than gains
– Investors will hang on to losing stocks hoping
they will bounce back

• Representativeness
– Investors tend to draw strong conclusions from
small samples
– Investors tend to underestimate the effects of
random chance

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 Investor Behavior
and Security Prices (cont’ d)

• Narrow Framing
– Investors tend to analyze a situation in isolation,
while ignoring the larger context

• Belief Perseverance
– Investors tend to ignore information that
conflicts with their existing beliefs
• Familiarity Bias
– Investors buy stocks that are familiar to them
without regard to whether the stocks are good
buys or not

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 Behavioral Finance
at Work in the Markets

• Stock Return Predictability

– It maybe profitable to buy underperforming
stocks when they are out-of-favor
– Momentum of stock prices up and down tends to
continue over 6- to 12-month time horizons
– Value stocks may outperform growth stocks

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 Behavioral Finance
at Work in the Markets (cont’ d)

• Investor Behavior
– Investors who believe they have superior
information tend to trade more, but earn lower
returns
– Investors tend to sell stocks that have risen in
value rather than declined
– Investors acting on emotions instead of facts
may reduce market efficiency

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 Behavioral Finance
at Work in the Markets (cont’ d)

• Analyst Behavior
– Analysts may be biased by “herding” behavior,
where they tend to issue similar
recommendations for stocks
– Analysts may be overly optimistic about a
favorite stock’s future

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 Using Behavioral Finance to Improve
Investment Results (Table 9.1)

• Don’t hesitate to sell a losing stock

• Don’t chase performance
• Be humble and open-minded
• Review the performance of your investment
on a periodic basis
• Don’t trade too much

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 Technical Analysis

• Before financial data/financial statements were

required to be disclosed, investors could only
watch the stock market itself to determine buy-or-
sell decisions
• Investors began keeping “charts” of stock market
movements to look for patterns, or “formations”
that indicated whether to buy or sell
• Studies have shown that anywhere from 20% to
50% of the price behavior of a stock can be traced
to overall market forces

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 Technical Analysis (cont’ d)

• Technical Analysis is the study of the various

forces at work in the marketplace and their affect
on stock prices.
– Focus is on trends in a business’ stock price and the
overall stock market
– Stock prices are a function of supply and demand for
shares of stock
– Used to get a general sense of where the stock market is
going in the next few months
– Several technical indicators may be used together

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 Market Technical Indicators

• Confidence Index
– Looks at ratio between yields on high-grade
corporate bonds compared to intermediate-
grade corporate bonds
– Optimism and pessimism about the future
outlook is reflected in the bond yield spread
– Trend of “smart money” is revealed in bond
market before it shows up in stock market

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 Market Technical Indicators
(cont’ d)
• Market Volume
– Pure supply and demand analysis for
common stocks
– Strong market when volume goes up
– Weak market when volume goes down

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 Market Technical Indicators (cont’ d)

• Breadth of the Market

– Looks at number of stock prices that go up
(advances) versus number of stock prices that
go down (declines)
– Strong market when advances outnumber
declines
– Weak market when declines outnumber
advances

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 Market Technical Indicators (cont’ d)

• Short Interest
– Looks at number of stocks that have been sold
short at any given time
– Can give two different interpretations:
• Measure of Future Demand for Stock
– Strong market when short sales are high since
guarantees future stock sales to cover the short positions
• Measure of Present Market Optimism or Pessimism
– Weak market when short sales are high since
professional short sellers think stocks will decline

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 Market Technical Indicators (cont’ d)

• Contrary Opinion and Odd-Lot Trading

– Measures the volume of small traders
– Assumes that small traders will do just the
opposite of what should be done
• Panic and sell when market is low
• Speculate and buy when market is high
– Bull market when odd-lot sales significantly
outnumber odd-lot purchases
– Bear market when odd-lot purchases
significantly outnumber odd-lot sales

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 Figure 9.5 Basic Market Statistics

(Source: http://finance.yahoo.com/advances, accessed August 12, 2012.)

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 Trading Rules and Measures

• Advance-Decline Line
– Measures the difference between stocks closing higher
and stocks closing lower than previous day
– Difference is plotted on graph to view trends
– Used as signal to buy or sell stocks
– Bull market when advances outnumber declines
– Bear market when declines outnumber advances

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 Trading Rules and Measures (cont’ d)

• New Highs–New Lows

– Measures the difference between stocks
reaching a 52-week high and stocks reaching a
52-week low
– 10-day moving average is plotted on graph to
view trends
– Used as signal to buy or sell stocks
– Bull market when highs outnumber lows
– Bear market when lows outnumber highs

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 Trading Rules and Measures (cont’ d)

• The Arms Index or Trading Index (TRIN)

– Combines advance-decline line with trading volume
– Used as signal to buy or sell stocks

– Bull market when TRIN values are lower

– Bear market when TRIN values are higher

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 Trading Rules and Measures (cont’ d)

• Mutual Fund Cash Ratio (MFCR)

– Tracks cash position of mutual funds
– High cash positions in mutual funds provides
liquidity for future stocks purchases or
protection from future mutual fund withdrawals

– Bull market when MFCR values are higher

– Bear market when MFCR values are lower

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 Trading Rules and Measures (cont’ d)

• On Balance Volume
– Tracks the volume to price change relationship
as a running total
– Up-volume occurs when stock closes higher and
is added to running total; down-volume occurs
when stock closes lower and is subtracted from
running total
– Direction of indicator is more important than
actual value
– Used to confirm price trends
– Bull market when OBV values are higher
– Bear market when OBV values are lower

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 Using Technical Analysis

• Charting
– Shows visual summary of stock activity over
time
– Easy to use and to understand
– Use to spot developing trends

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 Using Technical Analysis

• Chart Formations
– Looking for patterns, or formations, that
historically meant that stocks were going up or
down
– Buy when stocks break through a “line of
resistance”
– Sell when stocks break through a “line of
support”

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 Using Technical Analysis
(cont’ d)

• Moving Averages
– Tracks data (usually stock price) as average
value over time
– Used to “smooth out” daily fluctuations and focus
on underlying trends
– Usually calculated over periods ranging from 10
to 200 days

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 Figure 9.7 A 100-Day Moving
Average Line

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 Table 9.1 Using Behavioral Finance to Improve
Investment Results

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