Efficient Markets

Riccardo Colacito

Common wisdom
Two economists are walking down the street. They spot a $20 bill on the sidewalk. One starts to pick it up, but the other one says, Dont bother: if the bill were real someone would have picked it up already.

What does it mean?

If markets are efficient, then prices reflect all available information. That is no security is underpriced, i.e. theres no easy money. Is it true?

Analysis of the efficient market hypothesis

Proceed in three steps: 1. Formalize the concept of efficient markets 2. Look at the data 3. Explore competing explanations

The random walk hypothesis

Price changes should be random and unpredictable Randomness in price changes does not mean irrationality in the level of prices

Forms of Efficient Markets Hypothesis (EMH)

Prices contain
Information about history of past tradings
Weak form EMH

All publicly available information

Inside information

x
x x x x x
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Semistrong form EMH

Strong form EMH

EMH and Competition

Stock prices fully and accurately reflect publicly available information Once information becomes available, market participants analyze it Competition assures prices reflect information

Question
According to the strong EMH: whats your best guess for the price of a security tomorrow?
Todays price plus something that is random and unpredictable!

If there is no hope to outsmart the market, why bother?

1. Efficient diversification 2. Pick preferred level of risk

A role for stock analysis

Technical Analysis - using prices and volume information to predict future prices
Weak form efficiency & technical analysis

Fundamental Analysis - using economic and accounting information to predict stock prices
Semi strong form efficiency & fundamental analysis
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Insider trading
The Securities and Exchange Commission requires all insiders to register all their trading activity. SEC publishes these trades in an Official Summary of Security Transactions and Holdings since 2002.

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Are markets really efficient?

1. Patterns in stock returns 2. Anomalies 3. Competing explanations

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Patterns in stock returns

Serial correlation of stock market returns
Momentum Reversal

Short horizons: positive correlation Intermediate horizons: momentum effect Long horizons: negative serial correlation in the performance of aggregate market
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Anomalies
The small firm in January effect The neglected firm effect Book to market ratios Postearnings announcement price drift

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January effect

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Neglected firm effect

The tendency of investments in stock of less well known firms to generate abnormal returns

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Neglected firm effect

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Neglected firm effect: is it really a puzzle?

Information about such firms is less available Not a market inefficiency but a risk premium

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Book-to-market ratios

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Postearning announcement price drift

Sluggish response of stock prices to firms earnings announcements

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Trading costs?
Investors may refrain from buying securities due to high trading costs Hence prices fail to take into account the announcement fully and quickly

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A competeing explanation: the behavioral critique

Investors do not always process information correctly (come up with wrong forecasts) Investor make inconsistent or systematically suboptimal decision

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Mistakes in processing information

Forecasting errors Sample size neglect Overconfidence

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Behavioral biases
Framing: decisions are affected by how choices are framed Mental accounting: people segregate certain decisions Regret avoidance: people regret mistakes more when following unconventional decisions

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Behavioral critique: should we buy it?

Behavioral approach is too unstructured Any anomaly can be explained by some combination of irrationalities Lack of statistical significance of many tests Not yet mainstream

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The punch line

The market is competitive enough Only differentially superior information will earn money Easy pickings have been picked Enough anomalies in the empirical evidence to justify the search for underpriced securities

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