MARKET EFFICIENCY

INFORMATIONALLY EFFICIENT CAPITAL

MARKET
An informationally efficient capital market is one in
which the current price of a security fully, quickly,
and rationally reflects all available information about
that security.
Expected return on any security is just the
equilibrium return necessary to compensate
investors for the risk (uncertainty) regarding its future
cash flows

ACTIVE VERSUS PASSIVE INVESTMENT

STRATEGIES

Market
efficiency
Active
investment
strategies

INFORMATIONALLY EFFICIENT CAPITAL

MARKET
One method of measuring a market's efficiency is to
determine the time it takes for trading activity to
cause information to be reflected in security prices.

Note that market prices should not be affected by

the release of information that is well anticipated.

DISTINGUISH BETWEEN MARKET VALUE AND

INTRINSIC VALUE.

MARKET
VALUE

INTRINSIC
VALUE

FACTORS AFFECTING A MARKETS

EFFICIENCY
A market should be viewed as falling on a
continuum between two extremes:

Completely
Inefficient

Continuum

Completely
Efficient

FACTORS AFFECTING MARKET

EFFICIENCY

Availability of
information.

Number of market
participants.

Market
efficiency
Transaction and
information costs

Impediments to
trading.

WHAT FORM OF MARKET EFFICIENCY

EXISTS?

Abnormal
profits

WHAT GOOD IS TECHNICAL ANALYSIS?

Usefulness of
past data

Prevalence of
technical
analysis

WHAT GOOD IS FUNDAMENTAL

ANALYSIS?

Fundamental
analysis

Value-relevant
information
Possible
abnormal
returns

FORMS OF MARKET EFFICIENCY (FAMA 1970)

Market prices reflect:

Forms of market efficiency

Weak form of market
efficiency
Semi-strong form of market
efficiency
Strong form of market
efficiency

Past market
Public
Private
data
information information

WEAK FORM OF MARKET EFFICIENCY

Usefulness of
technical analysis

Tests of
weak form
market
efficiency

SEMISTRONG FORM OF MARKET

EFFICIENCY
Prices reflect
public
information

Fundamental
analysis

STRONG FORM OF MARKET EFFICIENCY

Past
information

Public
information

Private
information

Price

WHAT GOOD ARE PORTFOLIO MANAGERS?

Beat the
market

Manage
portfolio
objectives

MARKET PRICING ANOMALIES

Market
efficiency

Existence of
market
pricing
anomalies

EXHIBIT 3-3 SAMPLING OF OBSERVED

PRICING ANOMALIES

JANUARY (TURN-OF-THE-YEAR) EFFECT

Tax loss
selling
Window
dressing

Other
explanations

January
effect

EXHIBIT 3-4 OTHER CALENDAR-BASED

ANOMALIES

Overreaction
anomaly

Stock prices become inflated

(depressed) for those companies
releasing good (bad) news.

Momentum
anomaly

Securities that have experienced

high returns in the short term tend
to continue to generate higher
returns in subsequent periods.

OVERREACTION AND MOMENTUM

ANOMALIES

EARNINGS SURPRISE

Beginning
price

Ending price

Positive
earnings
surprise

Price rises

Price falls

Negative
earnings
surprise

BEHAVIORAL FINANCE VERSUS TRADITIONAL

FINANCE

Behavioral Finance
Assumes:
Investors suffer from
cognitive biases that
may lead to irrational
decision making.
Investors may overreact
or under-react to new
information.

Traditional Finance
Assumes:
Investors behave
rationally.
Investors process new
information quickly and
correctly.

OTHER BEHAVIORAL BIASES

Representativeness
Gamblers fallacy
Mental accounting
Conservatism
Disposition effect
Narrow framing

SUMMARY
Definition of efficient markets
Different forms of market efficiency
Evidence regarding market efficiency
Implications for fundamental analysis, technical
analysis, and portfolio management
Market pricing anomalies
Behavioral finance