Chapter 8-9 Stock Price Behavior and Market Efficiency

Market Efficiency

• The Efficient market hypothesis (EMH) is a theory that asserts: the prices of financial assets accurately reflect all relevant information at a given time.

• Market efficiency research question: is it possible for investors to consistently “beat the market?”

• Prediction of the EMH theory: if a market is efficient, it is not possible to “beat the market”, except by luck.

• What Does “Beat the Market” Mean?

“Beating the market” means consistently earning a positive excess return OR consistently earning a positive and significant Jensen’s alpha from CAPM or some other methodology.

Three forms of analysis & information used in the market:

• Technical analysis • historical price behavior, quantitative models, volume,

volatility, seasonal effects. • Fundamental analysis

• Company accounting data, CAPM, DDM, DCF, patents, product line, management effectiveness.

• “Inside Information” • Info available to CEO, CFO & significant officers, but not

known to public.Three Forms of Market Efficiency,

(i.e., what information is used?)

• A Weak-form Efficient Market: stock price fully reflects past price and trading activity of the security

A Weak-form Efficient Market is one in which past trading data (price, volume) are fully reflected in the market

– Therefore if you find anything you might think is useful that’s related to the past data, it is of no use in beating the market.

– If so, then technical analysis is of little use.

• A Semistrong-form Efficient Market means the stock price fully reflect all public information (which also includes past prices and trading info)

A Semistrong-form Efficient Market is one in which all publicly available information is already reflected fully in the market

– Therefore, anything new you may have uncovered from company research, DDM, CAPM analysis is of no use in beating the market.

– If so, then fundamental analysis is of little use.

A Strong-form Efficient Market means stock price fully reflects all information, public or private known only to insiders such as CEOs, CFOs, Major Officers, Directors.

• A Strong-form Efficient Market is one in which information of any kind, public or private, is already fully reflected in stock prices

• Therefore, any new info you uncovered is already fully reflected and is of no use in beating the market.

• If so, then “inside information” is of little use.

Information Sets for Market Efficiency

Why Would a Market be Efficient?

In an efficient market, all relevant information is incorporated in stock prices. Why would we expect that this is the case?

– The driving force is the profit motive.

– Even a relatively small performance enhancement due to uncovering a piece of relevant information can be worth a tremendous amount of money (when multiplied by the dollar amount of the investment involved).

– This creates incentives to unearth relevant information and use it.

• If many investors compete to discover relevant information and use that information in their trading decision, then information quickly incorporates into stock prices.

However, the efficient market requires not only that all information is incorporated in stock prices, but also that it is incorporated in stock prices accurately. Whether this condition for market efficiency holds, is still a subject of debate.

• Momentum and Reversal– Short-run price continuation (momentum)/long-run price reversal are

two well documented anomalies

– Buying past winners (best performing stocks in 6-12 months) can generate abnormal positive returns in 3-12 months (momentum)

– Buying past losers (worst performing stocks in past 5 years) can generate positive abnormal returns in the following three years (reversal)

– If these strategies indeed create abnormal returns, after trading costs are accounted for, then these findings put the validity of the weak form of efficiency in question

• Notes 11

• Behavioral Finance, Introduction

• Sooner or later, you are going to make an investment decision that winds up costing you a lot of money.

• Why did this happen ? – You made a sound decision, but you are “unlucky.”– You made a bad decision—one that could have been avoided.

• Beginning of investment wisdom:

– Learn to recognize your thinking process that led to poor decisions.– So that you can reduce your mistakes in the future.

• Behavioral Finance, Definition

• Behavioral Finance: The area of research that attempts to understand and explain how reasoning errors influence investor decisions and market prices.

• Comes from Cognitive psychology: – the study of how people (including investors) think, reason, and make

decisions.

• Investor behavior theories

• Prospect theory

• Investor overconfidence

• Sentiment-based risk

• Technical analysis• Prospect Theory

• A typical investor considers the pain of a $1 loss to be about twice as great as the pleasure received from the gain of $ 1.

• Also, investors respond in different ways to identical situations.

• Judgement errors consistent with Prospect Theory Predictions

– Frame Dependence

– Mental Accounting & loss aversion

– The House Money Effect

• Frame Dependence, I.

• Scenario One. Suppose we give you $1,000.

Then, you have to choose:

A. You can receive another $500 for sure.

B. You can flip a fair coin. If the coin-flip comes up “heads,” you get another $1,000, but if it comes up “tails,” you get nothing.

• Scenario Two. Suppose we give you $2,000.

Then, you have to choose:

A. You can lose $500 for sure.

B. You can flip a fair coin. If the coin-flip comes up “heads,” you lose another $1,000, but if it comes up “tails,” you lose nothing.

• Frame Dependence, II.

• But, the two scenarios are actually identical.

• In each scenario:

– You end up with $1,500 for sure if you pick option A.

– You end up with a 50-50 chance of either $1,000 or $2,000 if you pick option B.

• Phrasing, or framing issue ------ the way the question is asked causes people to answer the questions differently.

• Mental Accounting and Loss Aversion, I

• Consider your two investments:

Investment One. A year ago, you bought shares in Fama Enterprises for $40 per share. Today,

these shares are worth $20 each.

Investment Two. A year ago, you bought shares in French Company for $5 per share.

Today,these shares are worth $20 each.

• What will you do? • sell one of these stocks; • sell both of these stocks; • hold one of these stocks; or, • hold both of these stocks?

• Mental Accounting and Loss Aversion, II• Market is telling you that Fama shares are worth $20.

• If your current analysis tells you it’s not a good price, you sell.

• If your current analysis tells you, it’s a good buy, you buy.

• However, if you argued to yourself that if shares in Fama Enterprises were a good buy at $40, then they must be a steal or a very good buy at $20, you are fooling yourself.

• Decisions must be made based on its value, not what you think.

• The House Money Effect, I.

• Las Vegas casinos have found that gamblers are far more likely to take big risks with money that they have won from the casino (i.e., “house money”).

• Also, casinos have found that gamblers are not as upset about losing house money as they are about losing their own gambling money.

• The House Money Effect, II.

• Let us return to the shares of Fama Enterprises and French Company.

• Suppose shares in both were to decline to $15.

• You might feel very differently about the decline depending on which stock you looked at.

• The House Money Effect, III.

• Two important investment lessons here:

– Lesson One. There are no “paper profits.” Your profits are yours to keep.

– Lesson Two. All your money is your money. You should not separate your money into bundles labeled “my money” and “house money.”

• Overconfidence: A SignificantError in Investor Judgment

• We are all overconfident about our abilities in many areas.

• Do you think of yourself as a better than average driver?

– If you do, you are not alone.

– About 80 percent of the people who are asked this question will say

“YES”

• Overconfidence and Portfolio Diversification, I

• Investors tend to invest too heavily in shares of the company for which they work.

• This loyalty can be very bad financially.

• Another examples of the lack of diversification is investing too heavily in the stocks of local companies. Why?

– Someone you know works there.– You read about them in your local paper.– You are, probably incorrectly, confident that you have a high degree of

knowledge about local companies. • Overconfidence and Trading Frequency, II.

Is Overtrading “a Guy Thing?”

• Psychologists have found that men are more overconfident than women in the area of finance.

– Do men trade more than women? – Do portfolios of men under-perform the portfolios of women?

YES

• Men trade about 50 percent more than women.

• The portfolio return for men is 94 basis points lower than portfolio returns for women.

• The portfolio return for single men is 144 basis points lower than the portfolio return for single women.

• Accounting for the effects of marital status, age, and income, researchers also show that men invest in riskier positions.

• Technical Analysis

• Many investors try to predict future stock price movements based on investor sentiment, errors in judgment, and/or historical prices.

• These investors are using technical analysis.

• Technical analysis differs significantly from fundamental analysis.

• Unlike fundamental analysis, technical analysis does not rely on traditional stock valuation techniques.

• The Market Sentiment Index (MSI)

• Market Sentiment – Investors outlook on direction of the market or a stock

• They believe that once 80% of the investors are bullish or bearish, a “consensus” has been reached.

• Once a consensus is reached, they believe there is an impending turn in the direction of the market.

• One way to measure market sentiment is to ask investors whether they think the market is going up or down.

• The Market Sentiment Index, II.

• 50 investors are asked whether they are “bullish” or “bearish” on the market over the next month—20 say “bearish.”

• The Market Sentiment Index (MSI) can then be calculated as:• The Market Sentiment Index, III.

• The MSI has a maximum value of 1.00, direction change to Bull Market

• The MSI has a minimum value of 0.00, direction change to Bear Market

• Support and Resistance Levels• Support level is a price Market is unlikely to go further below.

• Resistance level is a price Market is unlikely to go any higher.

• Support and resistance levels are “psychological barriers:”

– bargain hunters help “support” the lower level.– profit takers “resist” the upper level.

How?

• A “breakout” occurs when a stock (or the market) passes through either a support or a resistance level.