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Emh teach

  1. 1. Efficient MarketEfficient Market HypothesisHypothesis
  2. 2. CHAPTER 12 OVERVIEW 12.112.1 Efficient Market ConceptEfficient Market Concept 12.212.2 Efficient Market HypothesisEfficient Market Hypothesis 12.312.3 Time Series Index of Stock PricesTime Series Index of Stock Prices 12.412.4 Random Walk TheoryRandom Walk Theory 12.512.5 Failures of Technical AnalysisFailures of Technical Analysis 12.612.6 Measuring Relative PerformanceMeasuring Relative Performance 12.712.7 Professional Investment ManagementProfessional Investment Management
  3. 3. Efficient Market Concept  Information is Power:Information is Power:  Street professionals seek bargainStreet professionals seek bargain stocks 24/7stocks 24/7  information is serious businessinformation is serious business  Coin Flipping Contest:Coin Flipping Contest: investmentinvestment metaphor for gamblingmetaphor for gambling  short-term speculation in stocksshort-term speculation in stocks and bonds = buying lottery ticketsand bonds = buying lottery tickets  winning tips are probably wrongwinning tips are probably wrong
  4. 4. Efficient Markets  In an efficient stock market, the price for anyIn an efficient stock market, the price for any given stock effectively represents the expectedgiven stock effectively represents the expected net present value of all future profitsnet present value of all future profits  Interplay of supply and demand sets pricesInterplay of supply and demand sets prices  Price for any stock or bond represents collectivePrice for any stock or bond represents collective wisdom about future prospectswisdom about future prospects
  5. 5. Efficient Markets Hypothesis  EMH holds that security prices fully reflect allEMH holds that security prices fully reflect all available information at any time.available information at any time.  Individual and professional investors buy and sellIndividual and professional investors buy and sell stocks under assumption that intrinsic value differsstocks under assumption that intrinsic value differs from market price.from market price.  Perfectly competitive securities market:Perfectly competitive securities market:  New information arrives at market independently andNew information arrives at market independently and randomly.randomly.  Both buyers and sellers adjust rapidly to new info.Both buyers and sellers adjust rapidly to new info.  Current security prices reflect all relevant risk/return info.Current security prices reflect all relevant risk/return info.
  6. 6. Levels of Market Efficiency  Weak-Form Hypothesis:Weak-Form Hypothesis: current prices reflect all stockcurrent prices reflect all stock market information; trading rules based on past stockmarket information; trading rules based on past stock market return or volume are futile.market return or volume are futile.  Semistrong-Form Hypothesis:Semistrong-Form Hypothesis: current prices reflect allcurrent prices reflect all public information; trading rules based on publicpublic information; trading rules based on public information are futile.information are futile.  Strong-Form Hypothesis:Strong-Form Hypothesis: current prices reflect allcurrent prices reflect all public information and non-public information. Allpublic information and non-public information. All trading rules are futiletrading rules are futile..
  7. 7. Public vs. Private Information  Stock Market Information:Stock Market Information: stock price andstock price and trading volume figurestrading volume figures  Public Information:Public Information: freely shared informationfreely shared information  Nonpublic Information:Nonpublic Information: proprietary dataproprietary data  Insider Information:Insider Information: proprietary informationproprietary information within a firmwithin a firm
  8. 8. Time Series of Stock Prices  Time Series:Time Series: date points over timedate points over time  Correlation among stock indexes is strong.Correlation among stock indexes is strong.  Daily Returns:Daily Returns: stock prices change irregularlystock prices change irregularly  Daily returns are noisy (highly variable) and randomDaily returns are noisy (highly variable) and random around a mean of zeroaround a mean of zero  Distribution of daily returns is normal; follows bell-shapedDistribution of daily returns is normal; follows bell-shaped curvecurve  Booms and Busts:Booms and Busts: reversion to the mean in day-to-dayreversion to the mean in day-to-day trading doesn’t worktrading doesn’t work
  9. 9. Random Walk Theory  Random Walk:Random Walk: irregular pattern of numbers thatirregular pattern of numbers that defies predictiondefies prediction  Random Walk Theory:Random Walk Theory: concept that stock priceconcept that stock price movements do not follow any pattern or trendmovements do not follow any pattern or trend  Fair Game:Fair Game: even bet; 50-50 chanceeven bet; 50-50 chance  Random Walk With Drift:Random Walk With Drift: slight upward bias toslight upward bias to inherently unpredictable daily stock pricesinherently unpredictable daily stock prices DJIA Prices
  10. 10. Evidence supports notion of random walkEvidence supports notion of random walk Random Walk Research Figure 12.4Figure 12.4
  11. 11. KEY TERMS Technical Analysis  Technical AnalysisTechnical Analysis  ChartistsChartists  Out-of-Sample ExperimentsOut-of-Sample Experiments  Data-Snooping ProblemData-Snooping Problem  Back TestingBack Testing
  12. 12. EMH & Technical Analysis  Tech Analysis:Tech Analysis: examining historicalexamining historical date on stock pricesdate on stock prices and trading volume toand trading volume to predict future pricespredict future prices  Chartist:Chartist: practitionerpractitioner of technical analysisof technical analysis Almost allAlmost all studies indicatestudies indicate that such focusthat such focus on past trends ison past trends is worthlessworthless
  13. 13. FAILURES OF TECHNICAL ANALYSIS Data-Snooping Problem  Data-Snooping Problem:Data-Snooping Problem: reliance on chancereliance on chance observations in historical data as guide toobservations in historical data as guide to investment decision making.investment decision making.  Out-of-Sample Experiment:Out-of-Sample Experiment: test of any historicallytest of any historically useful technical trading rule over some new sampleuseful technical trading rule over some new sample of data that was not used to derive that ruleof data that was not used to derive that rule  Back Testing:Back Testing: backward-looking analysisbackward-looking analysis
  14. 14. FAILURES OF TECHNICAL ANALYSIS Believing-is-Seeing Problem  Eager to believe in the possibility of beatingEager to believe in the possibility of beating the market, investors sometimes “see”the market, investors sometimes “see” results that do not really exist.results that do not really exist.  There is no robust (conclusive)There is no robust (conclusive) evidence that technicalevidence that technical trading rules can enhancetrading rules can enhance investor or trader profits.investor or trader profits.
  15. 15. Measuring Relative Performance  Investment Dartboard:Investment Dartboard: a blindfolded chimpanzeea blindfolded chimpanzee throwing darts atthrowing darts at The Wall Street JournalThe Wall Street Journal could do ascould do as well as experts in picking stocks.well as experts in picking stocks. Investors are better off buying an index fund that simply buys and holds a widely diversified portfolio of common stocks.
  16. 16. Investment Performance Benchmarks  Standards to compare performanceStandards to compare performance  Major Indexes:Major Indexes:  S&P 500:S&P 500: market value-weighted; 500 blue-chips;market value-weighted; 500 blue-chips; broadly representativebroadly representative  Wilshire 4500:Wilshire 4500: mid-cap proxymid-cap proxy  Russell 2000:Russell 2000: small-cap proxysmall-cap proxy  MSCI EAFE:MSCI EAFE: foreign stock market proxyforeign stock market proxy  Lehman Brothers Aggregate Bond IndexLehman Brothers Aggregate Bond Index
  17. 17. Beating the Market  Superior portfolio performanceSuperior portfolio performance  beating the market in terms ofbeating the market in terms of earning above-market investmentearning above-market investment returns with marketlike riskreturns with marketlike risk  earning marketlike returns from aearning marketlike returns from a portfolio with below-market riskportfolio with below-market risk  To measure risk and return:To measure risk and return: Style BoxStyle Box
  18. 18. Morningstar’s Innovative Nine-Part Style Boxes Allow Investors to Characterize Portfolio Risk & Return Table 12.5Table 12.5
  19. 19. Morningstar’s Innovative Nine-Part Style Boxes Allow Investors to Characterize Portfolio Risk & Return  Approximate techniqueApproximate technique  Separate Funds based on the median stock holdingsSeparate Funds based on the median stock holdings market capitalizationmarket capitalization  Calculate the median P/E and M/B ratios for each sizeCalculate the median P/E and M/B ratios for each size fund.fund.  Normalize each fund by the median fund sizeNormalize each fund by the median fund size
  20. 20. Professional Investment Management  A loser’s game?A loser’s game?  Impossible to beat the market over the longer term.Impossible to beat the market over the longer term.  If portfolio management had no costs, managementIf portfolio management had no costs, management fees, commissions,sales loads, operating expenses,fees, commissions,sales loads, operating expenses, etc., returns as a whole would match the market.etc., returns as a whole would match the market.  Zero Sum Game:Zero Sum Game: one investor’s gain is anotherone investor’s gain is another investor’s lossinvestor’s loss
  21. 21. Managed Portfolio Performance  Financial information readily available.Financial information readily available.  Today’s top-performing mutual fund becomesToday’s top-performing mutual fund becomes tomorrow’s average or underperformer.tomorrow’s average or underperformer.  Index funds outperform many comparableIndex funds outperform many comparable actively-managed funds.actively-managed funds.  Overwhelming evidence for EMH suggestsOverwhelming evidence for EMH suggests that best strategy is index funds.that best strategy is index funds.
  22. 22. Investment Professionals’ Role  Tailoring to investors’ tax considerations and riskTailoring to investors’ tax considerations and risk profilesprofiles  Age, tax bracket, risk aversion, employment statusAge, tax bracket, risk aversion, employment status  Investment professionals and media hostile toInvestment professionals and media hostile to EMHEMH  If every investor believed the EMH, no one wouldIf every investor believed the EMH, no one would analyze markets and the market would cease to beanalyze markets and the market would cease to be efficient.efficient.
  23. 23. KEY TERMS Efficient Market Hypothesis  coin-flipping contestcoin-flipping contest  efficient marketefficient market  efficient market hypothesisefficient market hypothesis  weak-form hypothesisweak-form hypothesis  stock market informationstock market information  semistrong-form hypothesissemistrong-form hypothesis  public informationpublic information  strong-form hypothesisstrong-form hypothesis  nonpublic informationnonpublic information  insider informationinsider information  time seriestime series  normal distributionnormal distribution  random walkrandom walk  random walk theoryrandom walk theory  fair gamefair game  random walk with driftrandom walk with drift  believing-is-seeing problembelieving-is-seeing problem  investment benchmarkinvestment benchmark  style boxstyle box  zero-sum gamezero-sum game

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