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. 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. 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. 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. 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. 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. 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. 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. Evidence supports notion of random walkEvidence supports notion of random walk
Random Walk Research
Figure 12.4Figure 12.4
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. 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. 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. 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. 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. 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
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. 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. 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. 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. 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
