FROM THE EFFICIENT MARKETS

HYPOTHESIS TO IRRATIONAL
EXUBERANCE
THE EMH: EUGENE FAMA
• An efficient capital market is a one that is efficient in processing information. The
prices of securities observed at any point in time are based on “correct”
evaluation of all information available at that time.

• In an efficient market, prices “fully reflect” available information

• Changes in prices would follow a “random walk”

(Chapter 5 of Foundations of Finance by Eugene Fama)

FORMS OF MARKET EFFICIENCY
• STRONG EFFICIENCY: ALL INFORMATION IS IMPUTED IN PRICES

• SEMI-STRONG EFFICIENCY: MOST INFORMATION (PAST AND

PRESENT) IS IMPUTED IN PRICES

• WEAK EFFICIENCY: ONLY PAST INFORMATION IS AVAILABLE AND

IMPUTED IN PRICES
Random Walks
• Statistical research has shown that to a close approximation stock
prices seem to follow a random walk with no discernible predictable
patterns that investors can exploit.
• Such findings are now taken to be evidence of market efficiency, that
is, evidence that market prices reflect all currently available
information.
• Only new information will move stock prices, and this information is
equally likely to be good news or bad news.
 0
50
100
150
200
250
300
350
400
450
01/02/50 500

01/02/52

01/02/54

01/02/56

01/02/58

01/02/60
RANDOM WALKS

01/02/62

01/02/64

01/02/66

01/02/68
Series1
01/02/70

01/02/72
Series2

01/02/74

01/02/76

01/02/78

01/02/80
Standard and Poor 500 Real Prices vs Random Prices
Random Prices have same Mean and Stdev as Original

01/02/82

01/02/84

01/02/86

01/02/88

01/02/90
THE EMH
In the most simple view price formation has two steps:

1. The “market” assesses probability distributions (means, standard

dev.)

2. The “market” sets prices

THE EMH
This can only be a completely accurate view of the world if all the
individual participants in the market:

(a) Have the same information

(b) Agree on its implications for distributions of future prices

EUGENE FAMA:
• “Neither of these conditions is completly descriptive, nor is realistic to
presume that when market prices are determined, they result from a
conscious assessment of disstributions of security prices by all or
most or even many investors”.

• “Moreover, this implies strong assumptions about the analytical

capabilities of investors” (Rational expectations)
EMH
• MARKETS RECOVER EQUILIBRIUM WHEN PRICES DEPART VISIBLY
FROM FUNDAMENTALS
• BY BALANCING LONG AND SHORT POSITIONS

i.E PREDICTIONS OF THE CAPITAL ASSET PRICING MODEL

 SECURITY MARKET LINE (From CAPM)
Ri = Rf +Beta*(Market Premium)

20.0%
18.0% investors will buy
16.0%
A undervalued
Expected Returns

14.0% A
12.0%
10.0%
P = DIV /r
8.0%
if the return is below its
6.0% equilibrium level the Price of
4.0% B investors will sell B
the asset will be above and
2.0% overvalued viceversa
0.0%
0 0.25 0.5 0.75 1 1.25 1.5 1.75 2 2.25

Betas
Efficient Markets and Investment Approach
• Proponents of the efficient market hypothesis often advocate passive
as opposed to active investment strategies.
• The policy of passive investors is to buy and hold a broad-based
market index.
• They expend resources neither on market research nor on frequent
purchase and sale of stocks.
• Passive strategies may be tailored to meet individual investor
requirements.
Passive versus Active Investment
• Passive fund assets have expanded rapidly recently. They manage
about $8 trillion or 20% of aggregate investment fund assets (2017) –
an increase of 8% from the previous decade, but remain concentrated
among equities
• The rising popularity of passive funds has displaced investment in
their active counterparts
• Net outflows from active funds were concentrated in 2013 and 2015
(market turbulence)
Passive vs Active Investing
• In principle, investors could earn superior returns by selecting those active funds that
outperform.
• But identifying such funds can be difficult in practice because it requires ex ante information
about the incentives and skill of a manager. Adopting a strict index-based investment strategy
therefore circumvents the main asymmetric information and agency problems arising from
delegating authority for investment decisions to a fund manager (Vayanos and Woolley (2016)).
• Notwithstanding the above arguments, there may still be a strong theoretical case for active
management. In reality passive fund managers must trade (albeit not frequently) to manage
investor inflows and outflows and because indices themselves are not static (Pedersen (2018))
• This means that, on average, informed active investors could outperform the benchmark by
taking advantage of passive managers' predictable trading patterns
Market consequences of increasing passive investment
• Passive investment decisions are made at the portfolio level and not at the
individual security level
• Passive managers sell and buy the entire basket of the index in responses to fund
inflows and outflows
• There is empirical evidence that this pattern increases market correlation and
might affect securities prices
• If “anomalies” in individual security prices emerge and/or increase, they might be
exploited by active managers increasing their participation
• Read this article for another view:
https://www.investopedia.com/articles/investing/091015/statistical-look-passive-
vs-active-management.asp
 BEHAVIORAL FINANCE
CONTESTS THE EFFICIENT MARKET HYPOTHESIS ON THE BASIS OF
IRRATIONAL BEHAVIORS AND FAILURES FROM THE MARKETS
BASICS OF BEHAVIORAL FINANCE

Behavioral finance is a field of study that emphasizes the importance of

human psychology in financial markets, leveraging research that
demonstrates how human beings are wired to make decisions that
contradict statistical evidence.

Investment strategies rooted in behavioral finance seek not only to

avoid the pitfalls of irrational behavior but also to exploit the
opportunities that arise from investor’s illogical decisions (Dennis Ruhl,
JPM)
 Behavioral Finance

Conventional Finance Behavioral Finance

• Prices are correct and equal to • What if investors don’t behave
intrinsic value rationally?
• Resources are allocated
efficiently
• Consistent with EMH
 The Behavioral Critique

Two categories of irrationalities:

1. Investors do not always process information correctly

• Result: Incorrect probability distributions of future returns
2. Even when given a probability distribution of returns, investors may make
inconsistent or suboptimal decisions
• Result: They have behavioral biases
 Errors in Information Processing:
Misestimating True Probabilities

1. Forecasting Errors: Too much weight is placed on recent

experiences

2. Overconfidence: Investors overestimate their abilities and the

precision of their forecasts

3. Conservatism: Investors are slow to update their beliefs and under

react to new information

4. Sample Size Neglect and Representativeness: Investors are too quick

to infer a pattern or trend from a small sample
 Behavioral Biases: Examples

1. Framing
• How the risk is described, “risky losses” vs. “risky gains,” can
affect investor decisions

2. Mental Accounting
• Investors may segregate accounts or monies and take risks with
their gains that they would not take with their principal
Behavioral Biases: Examples

3. Regret Avoidance
• Investors blame themselves more when an unconventional or
risky bet turns out badly
4. Prospect Theory
• Conventional view: Utility depends on level of wealth
• Behavioral view: Utility depends on changes in current wealth
Prospect Theory
HERD BEHAVIOR
• Herd Behavior describes how individuals in a group can act together
without planned direction. The term pertains to the behavior of
animals in herds and to human conduct during activities such as stock
market bubbles and crashes, sporting events and everyday decision-
making.
• Stock market trends often begin and end with periods of frenzied
buying (bubbles) or selling (crashes). Many observers cite these
episodes as clear examples of herding behavior that is irrational and
driven by emotion—greed in the bubbles, fear in the crashes.
Individual investors join the crowd of others in a rush to get in or out
of the market.
OVERCONFIDENCE
• Overconfidence, a behavior regularly exhibited by individuals in which
they overestimate their knowledge, underestimate risks, and
exaggerate their ability to control events, leads investors to market
timing, often causing them to sell winners too early and hold onto
losers for far too long.
Market well-known
anomalies
Some Market Anomalies
• Small firms outperform large firms
• The neglected stock effect
• The January effect
• The book value effect
• Long-term reversal
Interpretation
• Lakonishok, Schleifer, and Vishney argue that these effects are
evidence of inefficient markets
• Fama, Frency, Merton argue that these effects can be explained by
higher risk premiums demanded by investors
Risk Premiums or Inefficiencies?
• While size and B/P are not risk factors, they act as proxys for determinants of risk as Fama-French
showed with their 3-factor model
• Thus, they argue they are consistent with efficient markets as higher returns are consistent with
higher risk
• The opposite interpretation is offered by Lakonishiok, Shleifer, and Vishney who argue that these
phenomena are evidence of systematic errors in the forecast of stock analysts.
• They believe analysts extrapolate past performance too far into the future. Thus they over price
stocks with recent good performance and underprice stocks with recent bad performances
• When they find out about the mistake, the reversal effect kicks in
• A study by La Porta finds that analysts are overly pessimistic about firms with low growth
prospects and overly optimistic about firms with high growth prospects
Technical Analysis and Behavioral Finance

• Technical analysis attempts to exploit recurring and predictable

patterns in stock prices
• Prices adjust gradually to a new equilibrium
• Market values and intrinsic values converge slowly
• Disposition effect: The tendency of investors to hold on to losing
investments
• Demand for shares depends on price history
• Can lead to momentum in stock prices
 Technical Analysis: Trends and Corrections

• Momentum and moving averages

• The moving average is the average level of prices over a given interval of
time, where the interval is updated as time passes
• Bullish signal: Market price breaks through the moving average line
from below, it is time to buy
• Bearish signal: When prices fall below the moving average, it is time
to sell
Moving Average for INTC
 Technical Analysis:
A Warning
• It is possible to perceive patterns that really don’t exist
• Figure 12.6A is based on the real data
• The graph in panel B was generated using “returns” created by a random-
number generator
• Figure 12.7 shows obvious randomness in the weekly price changes
behind the two panels in Figure 12.6
Figure 12.6 Actual and Simulated Levels for Stock
Market Prices of 52 Weeks