Efficient Markets Hypothesis: Understanding Perfect and Efficient Markets, Slides of Finance

Download Efficient Markets Hypothesis: Understanding Perfect and Efficient Markets and more Slides Finance in PDF only on Docsity! Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion Ecient Markets Hypothesis Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion Table of Contents 1 Ecient Markets Hypothesis 2 Empirical Anomalies 3 Debate 4 Behavioral Finance 5 Adaptive Markets 6 Conclusion Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion What does perfect markets assumption buy us? Do we believe markets are perfect? No However, some markets are reasonable close to perfect to allow us to use this as a first working assumption It is not “is this market perfect?” but “to what extent is this market perfect?” Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion How perfect is the market for PepsiCo shares? 1 Opinions: modestly di↵erent (unless someone trades on insider information, but this is illegal ) 2 Many buyers and sellers: pretty close. On a typical day, around $250 million worth of PepsiCo shares change hands. 3 Transaction costs: low. Typical transaction costs for PepsiCo is about 5 cents on a $50 share price. 4 Taxes: depends on the seller’s and your tax status. Unfortunately not every good is traded in a perfect market. Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion Perfect vs. Ecient Markets An ecient market is one that sets the price correctly. Historically, there has been much confusion here: most people mean perfect markets when they say ecient markets. Perfect Market ) Ecient Market but Perfect Market (// Ecient Market One way to help dispell the confusion: when we talk about ”ecient markets” think instead of ’reflective markets’. In fact, people now refer to ’informationally ecient’ markets to distinguish it from other notions of eciency, such as ’pareto eciency’. Throughout this lecture when we say ‘ecient’, we mean ‘informationally ecient’ Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion What could happen if the EMH is NOT correct? Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion What could happen EMH is NOT correct? Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion Illustration of EMH: The Challenger Crash Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion Illustration of EMH: The Challenger Crash Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion Illustration of EMH: The Challenger Crash Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion Illustration of EMH: The Challenger Crash Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion What is Technical Analysis? People who look at patterns of historical stock prices and try to predict the market with it. Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion If price changes are truly random, why do so many believe that prices follow patterns? Probably because most people do now know what randomness looks like. Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion Why is technical analysis pointless, according to EMH? If an equity’s price follows a cyclical pattern, the pattern will be quickly eliminated. Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion What is the historical empirical evidence? First-order: the U.S. financial markets are reasonably ecient with respect to public information. It is very dicult to get rich easily. Few funds manage to outperform. It is close to random. Second-order: There may be some “anomalies” that seem to o↵er a tiny bit more than what seems reasonable. Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion Empirical Anomalies The three main equities-related anomalies are Value vs. growth: stocks with high book-to-market ratios (value stocks) tend to outperform stocks with low book-to-market ratios (growth stocks). Size: Returns on equities with small market capitalizations (market value of the firm) tend to be greater the the returns on equities with large market capitalizations. Momentum: tendency of rising asset prices to rise further, and falling prices to keep falling (over the next days). There are non-equities and other more specialized anomalies, too. Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion Fund Performance How many funds should outperform the market 10 years in a row if none have skills? About half How many funds should outperform the market 10 years in a row if some have skills? A few more than half. How much data do you need to prove to investors that you are good? 100 years for few-stock strategies, 30 years for large-portfolio strategies Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion Fund Performance What do you think of contingent compensation—you pay me only if I give you a profitable stock pick? Will this not remedy the problem of ignorant managers not wanting to get into the business? Great—give half of all people the advice to buy, the other half the advice to sell. But, is it better to be compensated regardless of performance? Obviously, contingent compensation is better than non-contingent compensation, but the lack of downside participation means that this is not a cure-all. Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion What is the empirical evidence for EMH? The empirical evidence is pretty consistent with EMH. Momentum and maybe value/growth strategies have outperformed by just a little bit—though there appears to be “fat-tail” risk. Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion Why is this debate so hard to settle? Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion Reason 1: Joint Hypothesis Problem Joint Hypothesis Problem: You cannot say anything about market eciency by itself. You can only say something about the coupling of market eciency and some security price model. If prices do not follow CAPM predictions then it can either be that: 1 CAPM is the wrong model and EMH is correct but reflecting other model 2 CAPM is correct but EMH is wrong 3 Both CAPM and EMH are wrong Mainstream finance has taken view 1. Behavioral finance takes view 2 or 3 (the market is trying to price securities according to some rational model like CAPM but falling short because of human frailty). Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion Reason 1: Joint Hypothesis Problem You see that the price of IBM is such that you expect it to earn 20% over the next year. Can you conclude that the market is inecient? No. Maybe 20% is the right number. What sort of claims would reject EMH? An expected 10% in one day is contradicting EMH, because it is not plausible that any reasonable equilibrium model could tell you that you should earn 10% in one day. Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion Causality True market eciency implies unpredictable stock prices, i.e., strong or semi-strong form eciency. Strong or semi-strong form unpredictability does not imply true (underlying fundamentals-based) market eciency. Take “unpredictability” loosely here. It could be that expected returns themselves are time-varying, e.g., because the risk-profile is time-varying. In this case, it may be predictable that you get higher average returns when risk is higher. Unpredictable here means “relative to expectations.” Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion Some Common MISPERCEPTIONS of Ecient Markets Hypothesis “What about Warren Bu↵et? He became rich betting on specific stocks” By pure chance, some people will get rich on the stock market. Think about millions of people playing roullete. “According to EMH, investors are as well o↵ throwing darts to select stocks” The investor must still decide how much risk she wants in her portfolio and diversify. “Company’s stock prices don’t always rise with good news. In fact they fall with good news sometimes.” Prices will move up or down relative to expectations Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion Behavioral Finance Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion Behavioral Finance Market Participants Are Irrational Cognitive and Behavioral Biases Loss Aversion, Anchoring, Framing Overconfidence Overreaction Herding Mental Accounting Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion Example: Shiller (1981) Shiller has a famous article (1981) with this (now famous) graph: p is actual prices, p* is prices if we knew the future with certainty (discounted realized dividends) The title of the article is “Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?” published in the American Economic Review Sidenote: Steven Leroy and Richard Porter made the same argument in a paper published the same year in another top journal, Econometrica, but Shiller’s graph is what everyone remembers now. Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion Example: Shiller (1981) Shiller looked at this graph and concluded that prices move way to much compared to that predicted by subsequent dividends: it has to be psychological biases driving trades People are overconfident People dislike losing more than they like winning: loss aversion Others Proponents of EMH say: it is not only dividends, there is also expectations and covariance with marginal utility. For example, preferences with habit formation seem to explain the volatility quite well. Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion Adaptive Markets Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion Logical vs. Rational Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion Logical vs. Rational No Reaction to Emotional Stimuli: “to know, but not to feel” Impaired Emotional Response ! Irrationality Serious Implications For Decision-making What do we mean by rational? Left Brain/Right Brain Distinction is wrong Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion The Triune Model of the Brain Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion The Triune Model of the Brain Say the colours of the following words: Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion The Triune Model of the Brain Preferences are produced by the three brains Logical Reasoning Produced by Hominid Brain Emotional Stimulus Overrides Hominid Brain Preferences May Not Be Stable Over Time Preferences May Not Be Stable Over Circumstances What are your Ultimate Objectives? Will Your Actions Help or Hinder You? Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion The Adaptive Markets Hypothesis Behavioral Finance camp: “Most people investing in the market do not incorporate all available information” EMH camp: “You only need a few smart people with deep pockets to engage in arbitrage and set prices ’right’. The few smart investors will take all the money from “naive” investors until they are driven out of the market.” Adaptive Markets Hypothesis: EMH and Behavioral are both right and they are both wrong. Markets can be ecient or behavioral depending on the underlying population of naive vs. sophisticated investors. Biology theories of evolution and survival of the fittest help determine the composition of the underlying population of investors at any given point in time. Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion Key Points Perfect Market 6= Ecient Market Perfect Market ) Ecient Market but Perfect Market (// Ecient Market Two main challenges to EMH come from Empirical Anomalies and Behavioral Finance. The debate is hard (impossible) to settle because of: 1 Joint Hypothesis Problem 2 Low signal-to-noise ratio Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion Key Points What types of markets are more likely to be (in-)ecient? Think about the extent of market perfection. The closer a market is to being perfect, the more likely it is to being ecient, too. Of course, if the market is not perfect, there may not even be an ecient value. Ecient Markets Hypothesis Empirical Anomalies Debate Behavioral Finance Adaptive Markets Conclusion Additional References