Description
In finance, the efficient-market hypothesis (EMH), or the Joint Hypothesis Problem, asserts that financial markets are "informationally efficient". In consequence of this, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made.
Chapter 12
Efficient Market Hypothesis
CHAPTER 12 OVERVIEW
12.1 12.2 12.3 12.4 12.5 12.6 12.7 Efficient Market Concept Efficient Market Hypothesis Time Series Index of Stock Prices Random Walk Theory Failures of Technical Analysis Measuring Relative Performance Professional Investment Management
Efficient Market Concept
? Information is Power:
?
Street professionals seek bargain stocks 24/7
?
information is serious business
? Coin Flipping Contest: investment
metaphor for gambling
? ?
short-term speculation in stocks and bonds = buying lottery tickets winning tips are probably wrong
Efficient Markets
? In an efficient stock market, the price for any
given stock effectively represents the expected net present value of all future profits
? Interplay of supply and demand sets prices
? Price for any stock or bond represents collective
wisdom about future prospects
Efficient Markets Hypothesis
? EMH holds that security prices fully reflect all
available information at any time.
? Individual and professional investors buy and sell
stocks under assumption that intrinsic value differs from market price.
? Perfectly competitive securities market: ? New information arrives at market independently and randomly. ? Both buyers and sellers adjust rapidly to new info. ? Current security prices reflect all relevant risk/return info.
Levels of Market Efficiency
? Weak-Form Hypothesis: current prices reflect all stock
market information; trading rules based on past stock market return or volume are futile.
? Semistrong-Form Hypothesis: current prices reflect all
public information; trading rules based on public information are futile.
? Strong-Form Hypothesis: current prices reflect all
public information and non-public information. All trading rules are futile.
Public vs. Private Information
? Stock Market Information: stock price and
trading volume figures
? Public Information: freely shared information
? Nonpublic Information: proprietary data ? Insider Information: proprietary information
within a firm
Time Series of Stock Prices
? Time Series: date points over time
? Correlation among stock indexes is strong. ? Daily Returns: stock prices change irregularly ? Daily returns are noisy (highly variable) and random
around a mean of zero
? Distribution of daily returns is normal; follows bell-shaped
curve
? Booms and Busts: reversion to the mean in day-to-day
trading doesn’t work
Random Walk Theory
? Random Walk: irregular pattern of numbers that
defies prediction
? Random Walk Theory: concept that stock price
movements do not follow any pattern or trend
? Fair Game: even bet; 50-50 chance ? Random Walk With Drift: slight upward bias to
inherently unpredictable daily stock prices
DJIA Prices
Figure 12.4
Random Walk Research
Evidence supports notion of random walk
KEY TERMS Technical Analysis
? Technical Analysis ? Chartists
? Out-of-Sample Experiments
? Data-Snooping Problem ? Back Testing
EMH & Technical Analysis
? Tech Analysis:
examining historical date on stock prices and trading volume to predict future prices
? Chartist: practitioner
of technical analysis
Almost all studies indicate that such focus on past trends is worthless
FAILURES OF TECHNICAL ANALYSIS
Data-Snooping Problem
? Data-Snooping Problem: reliance on chance
observations in historical data as guide to investment decision making.
? Out-of-Sample Experiment: test of any historically
useful technical trading rule over some new sample of data that was not used to derive that rule
? Back Testing: backward-looking analysis
FAILURES OF TECHNICAL ANALYSIS
Believing-is-Seeing Problem
? Eager to believe in the possibility of beating
the market, investors sometimes “see” results that do not really exist.
? There is no robust (conclusive)
evidence that technical trading rules can enhance investor or trader profits.
Measuring Relative Performance
? Investment Dartboard: a blindfolded chimpanzee
throwing darts at The Wall Street Journal could do as well as experts in picking stocks. Investors are better off buying an index fund that simply buys and holds a widely diversified portfolio of common stocks.
Investment Performance Benchmarks
? Standards to compare performance
? Major Indexes:
? ? ? ? ?
S&P 500: market value-weighted; 500 blue-chips; broadly representative Wilshire 4500: mid-cap proxy Russell 2000: small-cap proxy MSCI EAFE: foreign stock market proxy Lehman Brothers Aggregate Bond Index
Beating the Market
? Superior portfolio performance
?
?
beating the market in terms of earning above-market investment returns with marketlike risk earning marketlike returns from a portfolio with below-market risk
? To measure risk and return:
Style Box
Table 12.5
Morningstar’s Innovative Nine-Part Style Boxes Allow Investors to Characterize Portfolio Risk & Return
Morningstar’s Innovative Nine-Part Style Boxes Allow Investors to Characterize Portfolio Risk & Return
? Approximate technique
?
Separate Funds based on the median stock holdings market capitalization Calculate the median P/E and M/B ratios for each size fund.
?
?
Normalize each fund by the median fund size
Professional Investment Management
? A loser’s game? ? Impossible to beat the market over the longer term. ? If portfolio management had no costs, management
fees, commissions,sales loads, operating expenses, etc., returns as a whole would match the market.
? Zero Sum Game: one investor’s gain is another
investor’s loss
Managed Portfolio Performance
? Financial information readily available. ? Today’s top-performing mutual fund becomes
tomorrow’s average or underperformer.
? Index funds outperform many comparable
actively-managed funds.
? Overwhelming evidence for EMH suggests
that best strategy is index funds.
Investment Professionals’ Role
? Tailoring to investors’ tax considerations and risk
profiles ? Age, tax bracket, risk aversion, employment status
? Investment professionals and media hostile to
EMH
? If every investor believed the EMH, no one would
analyze markets and the market would cease to be efficient.
KEY TERMS
Efficient Market Hypothesis
? coin-flipping contest
? efficient market ? efficient market hypothesis
? time series
? normal distribution ? random walk
? weak-form hypothesis
? stock market information ? semistrong-form hypothesis ? public information ? strong-form hypothesis ? nonpublic information ? insider information
? random walk theory
? fair game ? random walk with drift ? believing-is-seeing problem ? investment benchmark ? style box ? zero-sum game
doc_396072415.ppt
In finance, the efficient-market hypothesis (EMH), or the Joint Hypothesis Problem, asserts that financial markets are "informationally efficient". In consequence of this, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made.
Chapter 12
Efficient Market Hypothesis
CHAPTER 12 OVERVIEW
12.1 12.2 12.3 12.4 12.5 12.6 12.7 Efficient Market Concept Efficient Market Hypothesis Time Series Index of Stock Prices Random Walk Theory Failures of Technical Analysis Measuring Relative Performance Professional Investment Management
Efficient Market Concept
? Information is Power:
?
Street professionals seek bargain stocks 24/7
?
information is serious business
? Coin Flipping Contest: investment
metaphor for gambling
? ?
short-term speculation in stocks and bonds = buying lottery tickets winning tips are probably wrong
Efficient Markets
? In an efficient stock market, the price for any
given stock effectively represents the expected net present value of all future profits
? Interplay of supply and demand sets prices
? Price for any stock or bond represents collective
wisdom about future prospects
Efficient Markets Hypothesis
? EMH holds that security prices fully reflect all
available information at any time.
? Individual and professional investors buy and sell
stocks under assumption that intrinsic value differs from market price.
? Perfectly competitive securities market: ? New information arrives at market independently and randomly. ? Both buyers and sellers adjust rapidly to new info. ? Current security prices reflect all relevant risk/return info.
Levels of Market Efficiency
? Weak-Form Hypothesis: current prices reflect all stock
market information; trading rules based on past stock market return or volume are futile.
? Semistrong-Form Hypothesis: current prices reflect all
public information; trading rules based on public information are futile.
? Strong-Form Hypothesis: current prices reflect all
public information and non-public information. All trading rules are futile.
Public vs. Private Information
? Stock Market Information: stock price and
trading volume figures
? Public Information: freely shared information
? Nonpublic Information: proprietary data ? Insider Information: proprietary information
within a firm
Time Series of Stock Prices
? Time Series: date points over time
? Correlation among stock indexes is strong. ? Daily Returns: stock prices change irregularly ? Daily returns are noisy (highly variable) and random
around a mean of zero
? Distribution of daily returns is normal; follows bell-shaped
curve
? Booms and Busts: reversion to the mean in day-to-day
trading doesn’t work
Random Walk Theory
? Random Walk: irregular pattern of numbers that
defies prediction
? Random Walk Theory: concept that stock price
movements do not follow any pattern or trend
? Fair Game: even bet; 50-50 chance ? Random Walk With Drift: slight upward bias to
inherently unpredictable daily stock prices
DJIA Prices
Figure 12.4
Random Walk Research
Evidence supports notion of random walk
KEY TERMS Technical Analysis
? Technical Analysis ? Chartists
? Out-of-Sample Experiments
? Data-Snooping Problem ? Back Testing
EMH & Technical Analysis
? Tech Analysis:
examining historical date on stock prices and trading volume to predict future prices
? Chartist: practitioner
of technical analysis
Almost all studies indicate that such focus on past trends is worthless
FAILURES OF TECHNICAL ANALYSIS
Data-Snooping Problem
? Data-Snooping Problem: reliance on chance
observations in historical data as guide to investment decision making.
? Out-of-Sample Experiment: test of any historically
useful technical trading rule over some new sample of data that was not used to derive that rule
? Back Testing: backward-looking analysis
FAILURES OF TECHNICAL ANALYSIS
Believing-is-Seeing Problem
? Eager to believe in the possibility of beating
the market, investors sometimes “see” results that do not really exist.
? There is no robust (conclusive)
evidence that technical trading rules can enhance investor or trader profits.
Measuring Relative Performance
? Investment Dartboard: a blindfolded chimpanzee
throwing darts at The Wall Street Journal could do as well as experts in picking stocks. Investors are better off buying an index fund that simply buys and holds a widely diversified portfolio of common stocks.
Investment Performance Benchmarks
? Standards to compare performance
? Major Indexes:
? ? ? ? ?
S&P 500: market value-weighted; 500 blue-chips; broadly representative Wilshire 4500: mid-cap proxy Russell 2000: small-cap proxy MSCI EAFE: foreign stock market proxy Lehman Brothers Aggregate Bond Index
Beating the Market
? Superior portfolio performance
?
?
beating the market in terms of earning above-market investment returns with marketlike risk earning marketlike returns from a portfolio with below-market risk
? To measure risk and return:
Style Box
Table 12.5
Morningstar’s Innovative Nine-Part Style Boxes Allow Investors to Characterize Portfolio Risk & Return
Morningstar’s Innovative Nine-Part Style Boxes Allow Investors to Characterize Portfolio Risk & Return
? Approximate technique
?
Separate Funds based on the median stock holdings market capitalization Calculate the median P/E and M/B ratios for each size fund.
?
?
Normalize each fund by the median fund size
Professional Investment Management
? A loser’s game? ? Impossible to beat the market over the longer term. ? If portfolio management had no costs, management
fees, commissions,sales loads, operating expenses, etc., returns as a whole would match the market.
? Zero Sum Game: one investor’s gain is another
investor’s loss
Managed Portfolio Performance
? Financial information readily available. ? Today’s top-performing mutual fund becomes
tomorrow’s average or underperformer.
? Index funds outperform many comparable
actively-managed funds.
? Overwhelming evidence for EMH suggests
that best strategy is index funds.
Investment Professionals’ Role
? Tailoring to investors’ tax considerations and risk
profiles ? Age, tax bracket, risk aversion, employment status
? Investment professionals and media hostile to
EMH
? If every investor believed the EMH, no one would
analyze markets and the market would cease to be efficient.
KEY TERMS
Efficient Market Hypothesis
? coin-flipping contest
? efficient market ? efficient market hypothesis
? time series
? normal distribution ? random walk
? weak-form hypothesis
? stock market information ? semistrong-form hypothesis ? public information ? strong-form hypothesis ? nonpublic information ? insider information
? random walk theory
? fair game ? random walk with drift ? believing-is-seeing problem ? investment benchmark ? style box ? zero-sum game
doc_396072415.ppt