Chapter 10
Market Efficiency and
Behavioral Finance
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© 2007 Thomson South-Western
Efficient Financial Markets
 Informational efficiency
 Allocative efficiency
 Operational efficiency
 Efficient markets hypothesis (EMH): asserts
that financial asset prices fully reflect all
available information.
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Efficient Financial Markets
 Behavioral finance: asserts that because
traders in financial markets are human beings,
they are subject to all the foibles and fads that
bedevil human judgment in other spheres of
life.
Human errors do not simply “cancel out” in
markets, but cause prices to deviate far from
“fundamental value” in ways that market
competition does not immediately eliminate.
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Three Forms Of Market Efficiency
Weak Form
Financial asset (stock) prices incorporate all
historical information into current prices.
Past stock price changes cannot help you
predict future price changes.
Semi-strong
Form
Strong Form
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Stock prices incorporate all publicly
available information (historical and current).
Information in an SEC filing is incorporated
into a stock price as soon as it is made public.
Stock prices incorporate all information,
private as well as public.
Prices react as soon as new information is
generated.
Forms of Market Efficiency
 Weak-form
efficiency:
 Prices
will be unpredictable and will change
only in response to new information.
 This means prices follow a random walk.
and
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Forms of Market Efficiency
 Semi-strong-form
efficiency: asserts that
asset prices incorporate all publicly
available information.
 The
level of asset prices should correctly
reflect all pertinent historical, current, and
predictable future information that investors
can obtain from public sources.
 Asset prices should change fully and
instantaneously in response to relevant new
information.
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Semi-strong Form Efficiency and
Fundamental Analysis
Recall the definition of efficient markets: In an efficient
market, prices rapidly incorporate all relevant information.
Semi-strong form efficiency uses “all public information” as its
definition of “information.”
Earnings announcements
Annual reports
SEC filings
News reports
Examples
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Prices move so fast in response to public information that trading on it
profitably is nearly impossible!
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Forms of Market Efficiency
 Strong-form
efficiency: asset prices
reflect all information, public and private
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The Strong Form Of Market
Efficiency
Prices should reflect all information, public and
private.
 Usually
tested by seeing if corporate insiders earn
superior returns on their trades in company stock
 Evidence suggests insiders can “beat the market.”
Insiders’ decision to trade at corporate level may be
informative.
– If they think stock price too high, they will sell new stock.
– If they think stock price too low, they can re-purchase shares.
– Stock prices can affect their decision to use cash or stock in
mergers.
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Forms of Informational Market
Efficiency
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Empirical Evidence on Market
Efficiency
 Tests for return predictability
 Tests
of simple trading rules
 Tests of the effectiveness of technical
analysis
 Tests for return predictability
 Tests of the performance of newly issued
shares
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Event Studies
Suppose in the month of July (2003) 6 firms report earnings
early in the day on the following dates:
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Firm
Earnings
announcement date
Day +1
1
Tues 7-8-03
Wed 7-9-03
2
Thur 7-9-03
Fri 7-10-03
3
Wed 7-16-03
Thur 7-17-03
4
Fri 7-18-03
Mon 7-21-03
5
Tues 7-22-03
Wed 7-23-03
6
Wed 7-23-03
Thur 7-23-03
In event time, the earnings announcement date is day 0.
Return
Abnormal Return
Cumulative Abnormal
Event Studies
Abnormal return
10%
5%
The actual return minus the
expected return
0%
-5%
-10%
-5 -4
-3
-2
-1
0
+1
+2 +3 +4
Event Time (in days)
+5
Could just be the market index
return for the day, or the
market index return times the
beta of the firm reporting the
earnings announcement
The positive bump on day 0 implies that the earnings news was, on average
for these firms, better than expected!
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Because the line is flat after day 0, this means that the market fully
incorporated the earnings news on the event day…no additional upward or
downward price trend is seen.
Simple Trading Rule Tests
 Positive
serial correlation
 Negative serial correlation
 “Anomalies”
 day-of-the-week
 small-firm
effect
 January effect
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effect
Tests for the Effectiveness of
Technical Analysis
Most empirical research contradicts the
usefulness of technical analysis and supports
weak-form market efficiency.
 But in a recent study researchers asked
whether any of the standard pricing patterns
can be identified statistically (rather than
visually).

 they
find that several technical patterns are in fact
observed much more frequently than chance would
predict.
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Tests for the Effectiveness of
Technical Analysis
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Tests for Stock Market Underreaction
Whether stock prices underreact to important
but infrequent corporate events
 Whether stock prices tend to systematically
undereact to certain types of routine
information disclosures, particularly earnings
announcements and recommendations by
security analysts
 Whether buying prior-period “winners” or
selling prior-period “losers” is profitable these momentum studies have been by far
the most numerous and important

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Tests for Stock Market Overreaction

Value stock phenomenon: stocks in the
“loser” portfolio trade at low prices relative to
earnings, dividends, and other measures of
fundamental value.
 Study results were distorted by some very
large percentage gains (up to 3,500%) on
some very low-priced stocks
 Potential profits identified by the overreaction
studies are simply too large to be credible.
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Tests For Rapid Price Adjustment
Stock Splits
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Tests For Private Information




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Tests of the Profitability of Insider
Trading
Tests of Mutual Fund Investment
Performance
Tests of Pension Fund and Hedge Fund
Investment Performance
Tests of the Stock-Picking Abilities of
Security Analysts
The Behavioral Finance Critique
Of Market Efficiency

Behaviorists claim that financial markets are
irrationally volatile.
 Prone
to recurring bubbles, fads, and information
cascades
 An
information cascade occurs when a piece of
“information” rapidly travels through a large group of
market participants, influencing trading behavior and
being accepted as correct—whether it is or not.

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All three of these phenomena, if they in fact
exist, are inconsistent with market efficiency.
Behavioral Finance
Argues that market participants suffer from
systematic psychological biases that result in suboptimal decisions
Investors underreact to new information that
contradicts prior beliefs (e.g., dramatic change in
earnings).
Investors overreact to a string of similar
information (e.g., investors expect recent trends to
continue).
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Investors are overly confident in their ability to
identify misvalued stocks.
The Underreaction Phenomenon
Cumulative Abnormal Return
Stock-price momentum
The line that is going upward
is showing the returns on a
group of stocks that have (in
month 0) reported
unexpectedly high earnings.
0
-5 -4
-3
-2
-1
0
+1
+2 +3 +4
+5
The line that is trending down
is showing the returns on a
group of stocks that have (in
month 0) reported
unexpectedly low earnings.
Time (months)
Investors are under reacting to the recent good (bad) earnings news.
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Subsequent news after the announcement continues to be good (bad), so
investors didn’t fully realize how good (bad) the initial announcement was.
The Overreaction Phenomenon
Cumulative Abnormal Return
Stock-price momentum
The line that trends up and
then reverses represents
returns on stocks that have
performed very well for the
last several years, and vice
versa for the other line.
0
-5 -4
-3
-2
-1
0
+1
+2 +3 +4
+5
Time (years)
The time period we are looking at here is long--several years--and investors
are overreacting to a perceived long-term trend.
This is distinct from the previous slide where investors were--over a much
shorter time span--underreacting to brand new information.
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Theoretical Underpinnings Of Behavioral
Finance
 No
fully developed model of behavioral
finance, but behaviorists have
explained how markets might be less
than fully efficient
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Theoretical Underpinnings Of
Behavioral Finance
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Assessing Behavioral Finance and
Market Efficiency

Behaviorists present persuasive evidence that price
bubbles occur, and somewhat less-compelling
evidence that the U.S. stock market was grossly
overvalued near the turn of the century.

On balance, investors and managers are wise to take
the efficient markets hypothesis seriously.

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Even though the quantity of evidence challenging the EMH
has grown in recent years, stock prices and prices of other
financial assets are still largely unpredictable
What Does Market Efficiency Imply
For Corporate Financing?
How do markets process accounting and other
information releases?
 How do markets respond to corporate
financing announcements?
 How can managers devise a corporate
“communications” policy?

 Assume
that your words and actions have
consequences
 Assume that loose lips sink corporate ships
 Consider honesty to be the best policy
 Listen to your stock price
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