11Ch11&12 – MBA 566

Efficient Market Hypothesis vs. Behavioral Finance

Market EfficiencyRandom walk versus market efficiency

Versions of market efficiency

Technical analysis vs. fundamental analysis

Predictors of future returns and market anomalies

Behavioral finance

22Ch11&12 – MBA 566

Cumulative Abnormal Returns Around Takeover Attempts: Target Companies

33Ch11&12 – MBA 566

Stock Price Reaction to CNBC Reports

44Ch11&12 – MBA 566

Stock prices fully and accurately reflect publicly available information.Once information becomes available, market participants analyze it.Competition assures prices reflect information.What does competition mean here? -- page 351Is there a role for active portfolio management in an efficient market?

EMH and Competition

55Ch11&12 – MBA 566

Weak

Semi-strong

Strong

See page 348.

Forms of the EMH

66Ch11&12 – MBA 566

Technical Analysis - using prices and volume information to predict future prices.

Weak form efficiency & technical analysis

Chartist

Relative strength versus resistance levels

Fundamental Analysis - using economic and accounting information to predict stock prices.

Semi strong form efficiency & fundamental analysis

Types of Stock Analysis

77Ch11&12 – MBA 566

Technical Analysis

Relative strength – page 349

Resistence levels – upper bound or

Support levels – lower bound

Whether a workable technical trading rule will continue to work in the future once it becomes publicly known?

88Ch11&12 – MBA 566

Fundamental Analysis

Uses earnings and dividend prospects of the firm, expectations of future interest rates, and risk evaluation of the firm to determine proper stock prices.

Fundamental analysis is much beyond identifying well-run firms with good prospects. It is to identify companies better than every else’s estimate.

99Ch11&12 – MBA 566

Active ManagementSecurity analysis

Timing

Passive ManagementBuy and Hold

Index Funds

Active or Passive Management

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Even if the market is efficient a role exists for portfolio management:

Appropriate risk level

Tax considerations

Other considerations

Market Efficiency & Portfolio Management

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Event studies

Assessing performance of professional managers

Testing some trading rule

Empirical Tests of Market Efficiency

1212Ch11&12 – MBA 566

Magnitude Issue

Selection Bias Issue: investing in small stocks

Lucky Event Issue

Issues in Examining the Results

1313Ch11&12 – MBA 566

Weak-Form Tests

Serial Correlation

Momentum

Returns over Long Horizons

1414Ch11&12 – MBA 566

Predictors of Broad Market Returns

Fama and FrenchAggregate returns are higher with higher dividend ratios

Campbell and ShillerEarnings yield can predict market returns

Keim and StambaughBond spreads can predict market returns

1515Ch11&12 – MBA 566

P/E Effect

Small Firm Effect (January Effect)

Neglected Firm

Book-to-Market Effects

Post-Earnings Announcement Drift

Anomalies

1616Ch11&12 – MBA 566

Returns in Excess of Risk-Free Rate and in excess of the Security Market Line for 10 Size-Based Portfolios, 1926 – 2005

1717Ch11&12 – MBA 566

Average Monthly Returns as a Function of the Book-To Market Ratio, 1963 – 2004

1818Ch11&12 – MBA 566

Cumulative Abnormal Returns in Response to Earnings Announcements

1919Ch11&12 – MBA 566

Some evidence of persistent positive and negative performance.

Potential measurement error for benchmark returns.

Style changes

May be risk premiums

Mutual Fund Performance

2020Ch11&12 – MBA 566

Persistence of Mutual Fund Performance

2121Ch11&12 – MBA 566

Behavioral Finance

The premise of behavioral finance is that conventional financial theory ignores how real people make decisions and that people make a difference.

Investors Do Not Always Process Information Correctly

Investors Often Make Inconsistent or Systematically Suboptimal Decisions

2222Ch11&12 – MBA 566

Behavioral Biases

FramingDecisions seem to be affected by how choices are framed – page 387example

Mental AccountingA special form of framing in which people segregate certain decisionsexample

Regret AvoidanceIndividuals would have more regrets when their decisions are more unconventionalexample

Prospect TheoryTraders become risk seeking after they lose money

2323Ch11&12 – MBA 566

Prospect Theory Graphs

2424Ch11&12 – MBA 566

Limits to Arbitrage

Fundamental Risk

Implementation Costs

Model Risk

2525Ch11&12 – MBA 566

Limits to Arbitrage and the Law of One Price

ViolationsSiamese Twin Companies

Equity Carve-outs

Closed-End Funds

2626Ch11&12 – MBA 566

Trend and Corrections

Dow theory – page 397 Primary trendSecondary/intermediate trend Tertiary or minor trends

Moving averageTypically 200 days or 53 weeksBullish versus bearish – page 398

Breadth – page 400Advances versus declines – page 401

Sentiment indicatorTrin statisticConfidence indexPut-call ratio