Stock Market Efficiency:
Alternative Views
Corporate Finance 27
Stock market efficiency: alternative views
• Views of professional investors
• Whether stock markets appear to absorb all relevant
(public or
private) information (strong-form
efficiency)
• The behavioural-based arguments leading to a belief
inefficiencies
• The implications of the evidence for efficiency for
and corporate management
in
investors
Comment on the semi-strong efficiency evidence
• Despite the evidence of some work showing departures from
semi-strong efficiency, for most investors most of the time the
market may be regarded as efficient
• The evidence for semi-strong efficiency is significant but not
so overwhelming that there is no hope of outperformance for
the able and dedicated
• Publication bias
• Hundreds of researchers examining the data
• A lot of evidence of inefficiency that remains hidden
• Paradox: in order for the market to remain efficient there has
to be a large body of investors who believe it to be inefficient
The views of some successful investors
• Peter Lynch
– Quantitative analysis taught me that the things I saw happening at
Fidelity couldn’t really be happening. I also found it difficult to integrate
the efficient market hypothesis… It also was obvious that the Wharton
professors who believed in quantum analysis and random walk weren’t
doing nearly as well as my new colleagues at Fidelity
• John Neff
– Always on the lookout for out-of-favour, overlooked or misunderstood
stocks
– He believes that the market tends to allow itself to be swept along with
fads, fashions and flavours of the month. This leads to overvaluation of
those stocks regarded as shooting stars, and to the undervaluation of
those which prevailing wisdom deems unexciting, but which are
fundamentally good stocks
The views of some successful investors
• Benjamin Graham
– ‘The prices of common stock are not carefully thought out
computations,but the resultants of a welter of human reactions.
The stock market is a voting machine rather than a weighing
machine’
– The processes by which the securities market arrives at its
appraisals are frequently illogical and erroneous. These
processes . . . are not automatic or mechanical, but
psychological for they go on in the minds of people who buy
and sell. The mistakes of the market are thus the mistakes of
groups of masses of individuals. Most of them can be traced to
one or more of three basic causes: exaggeration,
oversimplification, or neglect
The views of some successful investors
• Warren Buffett and Charles Munger
I’m convinced that there is much inefficiency in the market . . .
When the price of a stock can be influenced by a ‘herd’ on Wall
Street with prices set at the margin by the most emotional
person, or the greediest person, or the most depressed person,
it is hard to argue that the market always prices rationally. In
fact, market prices are frequently nonsensical . . . There seems
to be some perverse human characteristic that likes to make
easy things difficult. The academic world, if anything, has
actually backed away from the teaching of value investing over
the last 30 years. It’s likely to continue that way. Ships will sail
around the world but the Flat Earth Society will flourish
Strong-form tests
• It is possible to trade shares on the basis of information not in the
public domain and make abnormal profits
• Trading on inside knowledge is thought to be a ‘bad thing’
• Insider dealing is considered to be, besides dealing for oneself either
counselling or procuring another individual to deal in the securities or
communicating knowledge to any other person, while being aware
that he or she (or someone else) will deal in those securities
• The term ‘insider’ covers anyone with sensitive information, not just a
company director or employee
• Raise the level of information disclosure
• Prohibit certain individuals from dealing in the company’s shares for
crucial time periods
Behavioural finance
• Behavioural finance proponents argue that investors
frequently make systematic errors and these errors can push
the prices of shares away from fundamental value for
considerable periods
• Behavioural finance models offer plausible reasoning for the
phenomena we observe in the pattern of share prices
• They offer persuasive explanations for the outperformance of
low PER,high dividend yield and low book-to-market ratio
shares as well as the poor performance of ‘glamour’shares
• They also shed light on both return reversal and momentum
effects, stock market bubbles and irrational pessimism
The three lines of defence for EMH
1 Investors are rational and hence value securities rationally
2 Even if some investors are not rational, their irrationally
inspired trades of securities are random and therefore the
effects of their irrational actions cancel each other out
without moving prices away from their efficient level
3 If the majority of investors are irrational in similar ways and
therefore have a tendency to push security values away
from the efficient level this will be countered by rational
arbitrageurs who eliminate the influence of the irrational
traders on prices
Arbitrage
• Arbitrage is the act of exploiting price differences on the same
security or similar securities by simultaneously selling the
overpriced security and buying the underpriced security
• Perfect arbitrage: a profit without any risk at all (and even
without money)
• To be effective the arbitrageur needs to be able to purchase or
sell a close-substitute security
• For example you discover that Unilever’s shares are
undervalued
• The risk of other fundamental factors influencing the shares of
Unilever and P&G
• The risk that the irrational investors push irrationality to new heights
• ‘Risk arbitrage’ and risk-free arbitrage
Some cognitive errors made by investors
• The combination of limited arbitrage and investor
pushing the market leads to inefficient pricing
• Both elements are necessary
• Overconfidence
• Representativenes
• Conservatism
• Narrow framing
• Ambiguity aversion
sentiment
Some cognitive errors made by investors (continued)
• Positive feedback and extrapolative expectations
• Regret
• Confirmation bias
• Cognitive dissonance
• Availability bias
• Miscalculation of probabilities
• Anchoring
Misconceptions about the efficient market hypothesis
1 Any share portfolio will perform as well as or better
special trading rule designed to outperform the
market
than a
2 There should be fewer price fluctuations
3 Only a minority of investors are actively trading, most
passive, therefore efficiency cannot be achieved
are
Implications of the EMH for investors
1 For the vast majority of people public information
used to earn abnormal returns
cannot be
2 Investors need to press for a greater volume of timely
information
3 The perception of a fair game market could be
improved by more constraints and deterrents placed
dealers
on insider
Implications of the EMH for companies
1 Focus on substance, not on short-term appearance
2 The timing of security issues does not have to be
tuned
3 Large quantities of new shares can be sold without
the price
4 Signals from price movements should be taken
seriously
finemoving
Concluding comments
• Sophisticated stock markets are substantially efficient
• Question the assumption that all investors respond in a similar
manner to the same risk and return factors and that these can be
easily identified
• One way of ‘outperforming’ the market might be to select shares the
attributes of which you dislike less than the other investors
• Another way is through luck
• Possessing superior analytical skills
• Through the discovery of a trading rule which works
• To be quicker than anyone else
• To become an insider
Lecture review
• Strong-form efficiency
• Insider dealing
• Behavioural finance studies
• Implications of the EMH for investors
• Implications of the EMH for companies