efficient market hypothesis for basic students

8/2/2019 Efficient Market Hypothesis for Basic Students

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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


[3] Weak-form



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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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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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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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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.

efficient market hypothesis for basic students

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