The Efficient Market Hypothesis
(Covered in Chapter 14)
Capital Market Efficiency
Statement: Markets are “Information Efficient”
• Market participants processes new information as it “arrives”
• Prices adjust to new information and constantly find a new
equilibrium
Background: Why do security prices change?
• In other words: What causes the returns that we
observe?
• For example: Small Stocks have high expected returns
with high s
• In general the price of a stock is:
P0 = D1/(1 + R) + D2/(1 + R)2 + …
• But these are really expected D’s: E(D1), E(D2)…
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Market Efficiency Continued:
P0 = E(D1)/(1 + R) + E(D2)/(1 + R)2 + …
• As new information becomes available
– About the Economy, Industry, Company…
• People update their expectations about future CF’s
– They also change their required return (R)
• New information causes prices to change
– As Expected D’s and R’s change
– New information arrives at random times
– The “Direction” of the information is random (good news
or bad news)
– The Magnitude of the information is random
• So the prediction is that prices changes are random
– At least that’s the theory
– And for the most part, it’s actually a pretty good theory
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The Efficient Market Hypothesis (EMF)
Prices Reflect Information
• When new information becomes available:
– Market participants analyze the
information
– Then they buy or sell securities until prices
equal the new “equilibrium value”
– If there are more buyers than sellers at
$50, then the price goes up
– If there are more sellers than buyers at
$55, then the price goes down
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The Efficient Market Hypothesis (EMH)
• So what does the EMH predict?
• In other words:
“What should we observe if the EMH holds?”
1. Reaction to new information is swift
• Prices adjust to the new information
• No over reaction or delayed reaction
2. Securities are correctly priced
• You get what you pay for
• So you can’t beat the market
– Or maybe you can’t easily beat the market?
(What does beat the market really mean?)
Let’s look at the two EMH Predictions 
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1. Reaction to New Information is Swift
• A firm announces a new project with NPV = $40
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2. Securities are Correctly Priced
• What does correctly priced mean?
• The price of a security equals the risk-adjusted present value
of it’s expected CF’s:
P0 = CF1/(1 + R) + CF2/(1 + R)2 + …
0 = -P0 + CF1/(1 + R) + CF2/(1 + R)2 + …
0 = -CF0 + CF1/(1 + R) + CF2/(1 + R)2 + …
(Note that the right-hand side is the calculation for NPV)
• Correctly priced securities are zero NPV investments
– You get what you pay for
• So can you find mispriced securities?
• Or do prices correctly reflect information?
First let’s talk about what’s meant by information 
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Forms of the Efficient Market Hypothesis
1st Idea: “Prices Reflect All Information”
• We know this not strictly true since prices react to announcements.
– Like an earnings announcement
– Before the announcement, this information is know by the accountants, but
prices don’t react until the after the announcement
2nd Idea: “Prices Reflect All Available Information”
• Or all “Public” information
– If this is true, then securities analysts can’t find mispriced securities
– Without inside (illegal) information
• Is this true?
– Can analysts spend time & money to find mispriced securities?
– Does the evidence support this?
3rd Idea: “Prices Reflect All Easily Available Information”
• Or all “cheap” information
– If this is true, maybe market participants can’t predict securities prices using
just past prices
• Is this true?
– Can people without superior information or superior market access find
mispriced securities?
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Forms of the EMH (Continued)
Each idea represent a different “form” of the EMH:
• Strong Form:
– “Prices Reflect All Information”
• Semi-Strong Form:
– “Prices Reflect All Available Information”
• Weak Form:
– “Prices Reflect All Easily Available Information”
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Evidence Supporting or Contradicting the EMH
•
•
•
•
EMH predicts that you can’t find mispriced securities
The implication is that you can’t “beat the market”
But what does it mean to beat the market?
People often mean a return greater than the S&P 500
– The “Large Stocks” we category from the beginning of this chapter
– What is the historic mean return for large and small stocks?
Category
Large stocks
Small Stocks
Mean
11.7%
16.4%
• So all I had to do to “beat the market” is buy small stocks!
– Does that count as beating the market?
– Remember small stock are more volatile (more risk)!
• So a claim of market-beating returns must be risk-adjusted
–
–
–
–
There are many ways to adjust for risk
One way is to compare to returns to the same “style” index
Small, Mid-cap, Large Cap vs. Value, Balanced and Growth
We’ll do this for mutual funds
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EMH Evidence
• Can professional managers beat the market?
– Not a lot of evidence that they can
• Although maybe they are not trying to beat the market
• Maybe they just want to keep their jobs
• Can you look at a single manager’s performance?
– Maybe. Maybe not. (coin flips)
– 1,000 people flip a coin. 500 get heads…
• Look at all Active mutual fund managers:
–
–
–
–
Professional managed funds that must report performance
Compare funds to the appropriate style index
See tables from SPIVA Report
The full SPIVA report is on the Course Web site
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But First We’ll Consider Types of Companies
• As a way to account for risk
• Types of company can mean:
– Big, Middle or Small companies
– Companies in different industries
– Companies currently at the high end of the range of
PE and Market-to-Book ratios – called Growth
companies
– Companies currently at the low end of the range of PE
and Market-to-Book ratios – called Value companies
• What have the returns been in the past for these
types of companies?
• What about the return on bonds?
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Stock Categories:
A common way to categorized stocks
In order to account for know risk factors:
1. Market Value aka Market Cap
– Categories are Large, Mid and Small
– Multiply the price per share by number of shares
– This is what is costs to buy the company
2. The relative position of the company in the range of PE and
Market-to-Book ratios
– Categories are Growth, Balanced, Value
– Are you buying a company’s stock because
• You expect it to grow or because it has current profits?
• These two factors (3x3) create nine categories (called “styles”)
– Represented by “Style Boxes”
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Indices and ETF tickers that Track Each Style:
Value
Balanced
Growth
Large S&P 500 Value
(IVE)
S&P 500 S&P 500 Growth
(IVV)
(IVW)
Mid S&P 400 Value
(IJJ)
Small S&P 600 Value
(IJS)
S&P 400 S&P 400 Growth
(IJH)
(IJK)
S&P 600 S&P 600 Growth
(IJR)
(IJT)
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Can professional managers beat the market?
SPIVA Scorecard, Year-End 2010
Report 1: Percentage of U.S. Equity Funds Outperformed by Benchmarks
Fund Category
All Domestic Equity Funds
All Large Cap Funds
All Mid Cap Funds
All Small Cap Funds
All Multi Cap Funds
Large Cap Growth Funds
Large Cap Core Funds
Large Cap Value Funds
Mid Cap Growth Funds
Mid Cap Core Funds
Mid Cap Value Funds
Small Cap Growth Funds
Small Cap Core Funds
Small Cap Value Funds
MultiCap Growth Funds
MultiCap Core Funds
MultiCap Value Funds
Real Estate Funds
Comparison Index
S&P Composite 1500
S&P 500
S&P MidCap 400®
S&P SmallCap 600®
S&P Composite 1500
S&P 500 Growth
S&P 500
S&P 500 Value
S&P MidCap 400 Growth
S&P MidCap 400
S&P MidCap 400 Value
S&P SmallCap 600 Growth
S&P SmallCap 600
S&PSmallCap 600 Value
S&P Composite 1500 Growth
S&P Composite 1500
S&P Composite 1500 Value
S&P BMI United States REIT
One Year
49.31
65.72
73.75
53.42
63.90
49.86
76.25
71.30
83.65
87.18
57.73
61.63
59.27
39.52
47.37
70.67
68.63
75.71
Three Year
51.68
57.65
83.90
70.11
60.84
78.67
60.83
31.44
94.89
83.64
71.72
83.59
65.78
52.94
85.28
56.16
50.96
72.57
Five Year
57.63
61.83
78.19
63.02
66.28
82.00
63.20
34.67
82.14
82.00
71.76
72.68
60.21
51.81
78.79
61.22
59.35
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68.83
EMH Evidence
• Conclusion: Can you beat the market?
– Really: Can you beat the market on a risk-adjusted basis?
• There are lots of studies
• Conclusion:
– With knowledge and hard work you can find
mispriced securities
– But there does not appear to be an easy way to
do so
– This would support the Weak-Form of the EMH
• So can you find mispriced securities often enough to
continually beat the market?
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