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Efficient Market Hypothesis
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A hypothetical scenario
What if you have figured out the following:
Buy if out of the 20 trading days for the past
month, stock XYZ has been rising for more than
10%.
Sell if out of the 20 trading days for the past
month, stock XYZ has been falling for more than
10%. Follow this rule strictly, return is abnormally
high.
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If you have spotted such price pattern that seems to guarantee youa sure profit, what should you do?
You should definitely exploit it. (How? Borrow as much as youcan to invest according to your strategy.)
The process of exploiting the pattern actually ironically destroy the
pattern because: You would bid up XYZ share price when you think it is hot.
Price => Expected[Return]
You would bid down XYZ share price when you think it is cold. Price => Expected[Return]
The fact that you have figured out a stock price movement is verylikely to be reflected by the stock price.
The more greedy (which is rational. More precisely, is the higher theability for you to raise fund) you are, the faster the pattern will beeliminated by your own hands.
Bottom line: info, private or public, is reflected in stock prices.
Stock price reflects information
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Price movement pattern
Stock
Price
Time
Investors behaviors tend to eliminate any profitopportunity associated with stock price patterns.
If it were possible to make
big money simply by
finding the pattern in the
stock price movements,
everyone would have done
it and the profits would be
competed away.
Sell
Sell
Buy
Buy
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You are not alone in the market
Imagine not only you, there is essentially an army ofintelligent, well-informed security analysts, traders, wholiterally spend their lives hunting for mispriced securities orsecurities that follow a pattern based on currently availableinformation.
They have high-tech computers, subscription to professionaldatabase, up-to-date information on thousands of firms,state-of-the-art analytical technique, etc.
These people can assess, assimilate and act on information,very quickly.
In their intense search for mispriced securities, professionalinvestors may police the market so efficiently that theydrive the prices of all assets to fully reflect all availableinformation.
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Implications Competition for finding mispriced securities is fierce.
Such competition always kills the sure-profit pattern.Were there one, it would have been exploited bysomeone who first spotted it. Thus, roughly speaking,no arbitrage should hold.
The first one does make abnormal profit, butEconomic profit gross profit
The very first one is not likely to be you.
Even if you are the very first one, you are likely to payhigher brokerage and commission fees than institutional
investors and professional traders The implications:
stock prices should have reflected all availableinformation.
stock prices should be unpredictable.
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Unpredictability
Prices are unpredictable in the
sense that stock prices should
have reflected all available
information.
Thus if stock prices change, it
should be reacting only to new
information.
The fact that information is new
means stock prices areunpredictable.
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Market efficiency
If all past information is incorporated in the price
then it should be impossible to consistently beat the
market using technical analysis and the like.
Definition 1: Eugene Fama defined Market Efficiency as the state where
"security prices reflect all available information.
Definition 2:
Financial markets are efficient if current asset prices fully
reflect all currently available relevant information.
http://www.e-m-h.org/definition.htmlhttp://www.e-m-h.org/definition.html -
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The right question to ask
If new information becomes known about aparticular company, how quickly do marketparticipants find out about the information and buyor sell the securities of the company based on theinformation?
How quickly do the prices of the securities adjust toreflect the new information?
The issue is not merely black or white. We know thatthe market should neither be strictly efficient norstrictly inefficient. The question is one of degree.
We should ask how efficient the market really is?
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Subsets of available information
for a given stock
Information
in past stock
prices
All Public Information
All Available Information
including inside or private
information
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3 forms of market efficiency hypothesis
Information
in past stock
prices
All Public Information
All Available Information
including inside or private
information
Since we are more interested in how
efficient is the capital market, we define
the following 3 forms of market efficiency
hypothesis:
A market is efficient if it reflects ALL
available information
[1] Strong-form
- ALL available info
[2] Semi-strong form
- ALL available info
[3] Weak-form
- ALL available info
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3 forms of market efficiency hypothesis Weak-form
Stock prices are assumed to reflect any information that may becontained in the past stock prices.
For example, suppose there exists a seasonal pattern in stockprices such that stock prices fall on the last trading day of theyear and then rise on the first trading day of the following year.Under the weak-form of the hypothesis, the market will come torecognize this and price the phenomenon away.
Anticipating the rise in price on the first day of the year, traderswill attempt to get in at the very start of trading on the first day.Their attempts to get in will cause the increase in price to occur
in the first few minutes of the first day. Intelligent traders willthen recognize that to beat the rest of the market, they willhave to get in late on the last day. The consequences, therefore,is the elimination of the pattern as price in the last trading dayshould be bid up.
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3 forms of market efficiency hypothesis
Semi-strong-form
Stock prices are assumed to reflect any informationthat is publicly available.
These include information on the stock price
series, as well as information in the firmsaccounting reports, the past prices and reports ofcompeting firms, announced information relatingto the state of the economy, and any other
publicly available information relevant to thevaluation of the firm.
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3 forms of market efficiency hypothesis
Strong-form
Stock prices are assumed to reflect ALLinformation, regardless of them being public orprivate.
Under this form, those who acquire insiderinformation act on it, buying or selling the stock.Their actions affect the price of the stock, and theprice quickly adjusts to reflect the insider
information.
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3 forms of market efficiency hypothesis
If Weak-form of the hypothesis is valid:
Technical analysis or charting becomes ineffective. You wont beable to gain abnormal returns based on it.
If Semi-strong form of the hypothesis is valid:
No analysis will help you attain abnormal returns as long as the
analysis is based on publicly available information. If Strong-form of the hypothesis is valid:
Any effort to seek out insider information to beat the marketare ineffective because the price has already reflected theinsider information. Under this form of the hypothesis, theprofessional investor truly has a zero market value because noform of search or processing of information will consistentlyproduce abnormal returns.(Even if Steve Jobs is your uncle, you cant profit from listeningto his phone calls and trading APPLE stocks.)
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Expected return-risk The Efficient Market Hypothesis imposes no structure on stock
prices. However, what is abnormal return?Abnormal return = Actual return Expected return
This means we have to know what exactly is expected return.
Thats why we may rely on an asset pricing model.
e.g.,CAPM, to find a risk-adjusted return that the market will be
rewarding.) Defining abnormal return inherently involves assuming a pricing
model. If we find abnormal returns, we conclude that the market isinefficient. But then, we can also say that the pricing model weused is invalid.
The challenge here is: testing market efficiency inevitably involvestesting a joint hypothesis:
H0 : both market is efficient and the pricing model is valid.
H1 : EITHER market is inefficient OR the pricing model is invalid.
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4 basic traits of efficiency
An efficient market exhibits certain behavioral
traits. We can examine the real market to see if it
conforms to these traits. If it doesnt, we can
conclude that the market is inefficient.
1. Act to new information quickly and accurately
2. Price movement is unpredictable (memory-less)
3. No trading strategy consistently beat the market
4. Investment professionals not that professional
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1) Act to news quickly & accurately
0 +t-t
The timing for a positive news
Days relative to announcement dayStock
price
($)
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1) Act to news quickly & accurately
0 +t-t
Days relative to announcement dayStock
price
($)
If the market is efficient,
1) at time 0, the positive news come, there is an immediate jump of the share
price to the RIGHT level. (i.e., the PINK path)
2) There is no delays in analyzing news and slowly reflecting in the share price
like the ORANGE path does.
3) There is also no over-reaction like the BLUE path does, and then
subsequently adjustment back to the correct level.
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2) Memory-less price movementIf the market is efficient (WEAK-FORM),
1) The so-called momentum is nothing. (Google Stock momentum)
momentum is like, if once started on a downward slide, stock prices
develop a propensity to continue sliding. The expected change in
todays price would, in fact, be related (correlated positively) with the
price changes in the past.
2) If the market is efficient, prices only move in response to news. More
precisely, news is any discrepancy between the publics expectation and
the actual realized event.
E.g, Suppose everyone expects RIMs sales should have gone up by 30%. If
RIM does announce that its sales has gone up by 30%, it is not a news. If it
has gone up by 29% instead, it is a news, a negative one though.
3) To detect memory or momentum, we try to see if
Cov(Pt, Pt-i)is significantly different from zero or not, for i 0
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3) No superior trading strategies One way to test for market efficiency is to test whether a specific trading
rule or investment strategy, would have CONSISTENTLY produced
abnormally high return.
Problem about such test is:
1. What is abnormal return again? We run into the problem of joint
hypothesis testing again in order to find an expected return as
benchmark.
2. What kind of information you use to construct an investment
strategy? Can you be sure the information you are based on really
reflect what WAS available when the decision to invest was made.
E.g., Last quarters earning is out around February of next year. Ifa WINNING investment strategy says invest in the top 10
companies last year by Jan, it is not an employable strategy.
3. What is the cost of implementing a strategy?
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4) Professionals arent that professional
If professional investors consistently beat the market, we conclude that the
market is not that efficient.
If the market is really efficient, we should not see professionals making
abnormally high returns.
The puzzle is: we do see professionals, like Peter Lynch and Warren Buffet,
having amazing records.
A defense, a weak one though, is:
Suppose we take a thousand people in a gigantic stadium. Have them
flip coins. Suppose head is winning and tail is losing. There is no
surprise to find a few individual flippers with unbelievable records of
success and failure. Those having 20 heads in a row goes on TV andshowcase their exceptional flipping skills. But we know theyre just
plain lucky.
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So whats the value for portfolio management
If capital markets are efficient, should we just throw darts at the financial
page to pick stocks instead of spending time carefully construct a stock
portfolio?
The answer is 3 NO NO NO.
As you have learnt, you need to have a well-diversified portfolio that is
tailored towards your risk-preference.
Depending on your age, your risk-preference, your current situation,
your tax bracket, and all other relevant factors, your portfolio should
be carefully constructed.
Dont forget that there is value for diversification. There is value for
you to learn options. There is value for you to tailor a future payoffprofile specific to your own needs. Throwing darts to pick stocks does
not guarantee your specific needs are met.
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So whats the value for portfolio management
The conclusion is:
capital market is neither purely efficient nor purely inefficient.
The right question to ask is the degree of efficiency of capital
market.
The more efficient capital market is, the better off the society.
But even if it is efficient, it doesnt imply knowledge of finance is
useless. Because you have learnt diversification and portfolio theory
that is based on maximizing happiness.
Price movements are random. But it in NO way implies prices are
random. Prices reflect/incorporate available information. The driving
force to their random movements is that news comes randomly.