Lecture Presentation Software

to accompany

Investment Analysis and

Portfolio Management
by
Frank K. Reilly & Keith C. Brown

Chapter 6
 Chapter 6
Efficient Capital Markets
Questions to be answered:
• What is meant by the concept that capital markets are
efficient?
• Why should capital markets be efficient?
• What are the specific factors that contribute to an
efficient market?
• Given the overall efficient market hypothesis, what
are the three sub-hypotheses and what are the
implications of each?
 Chapter 6
Efficient Capital Markets
• How do you test the weak-form efficient market
hypothesis (EMH) and what are the results of the
tests?
• How do you test the semistrong-form EMH and what
are the test results?
• How do you test the strong-form EMH and what are
the test results?
• For each set of tests, which results support the
hypothesis and which results indicate an anomaly
related to the hypothesis?
 Chapter 6
Efficient Capital Markets
• What are the implications of the results for
– Technical analysis?
– Fundamental analysis?
– Portfolio managers with superior analysts?
– Portfolio managers with inferior analysts?
• What is the evidence related to the EMH for
markets in foreign countries?
 Efficient Capital Markets
• The efficient market hypothesis (EMH) is an
investment theory.
• In an efficient capital market, security prices adjust
rapidly to the arrival of new information, therefore the
current prices of securities reflect all information about
the security
• There is no undervalued or over valued stock.it is
impossible to earn higher returns by using investing
strategies ,predict future price, expert stock selection or
stock timing. the only way an investor can possibly
obtain higher returns is by purchasing riskier
investments
 Efficient Capital Markets
• Whether markets are efficient has been
extensively researched and remains
controversial.
• Few reasons why it may b incorrect:
1.All investors view information differently&
therefore have different stock valuation
2.Stocks take time to reflect new information.one
who receives or act on this information first,
can take advantage of it.
 Efficient Capital Markets
3. Stock prices can be effected by human error &
emotional decision making.
4. Investors have proven that they can profit
from market anomalies.
if EMH is true than all the investors should earn
same returns as over all market.
 Why Should Capital Markets
Be Efficient?
The premises of an efficient market(informationally
efficient market)
– A large number of competing profit-maximizing participants
analyze and value securities, each independently of the others
– New information regarding securities comes to the market in
a random fashion
– Profit-maximizing investors adjust security prices rapidly to
reflect the effect of new information.
– Security prices adjust rapidly because the many profit-
maximizing investors are competing against one another to
profit from the new information.
 Why Should Capital Markets
Be Efficient?
Conclusion: the expected returns implicit in the
current price of a security should reflect its risk
 Alternative
Efficient Market Hypotheses (EMH)
• Early works
• Louis bachelier -french mathematician (1900) Random
Walk Hypothesis – changes in security prices occur
randomly. its unpredictable
• Browanian motion-random movement of particles in air.
• Fair Game Model(Fama 1970) – current market price
reflect all available information about a security and the
expected return based upon this price is consistent with its
risk
• Efficient Market Hypothesis (EMH) - divided into three
sub-hypotheses depending on the information set involved
Efficient Market Hypotheses (EMH)
• Forms of EMH depends on “what u mean
by available information”
• Weak-Form EMH - prices reflect all
security-market information
• Semistrong-form EMH - prices reflect all
public information
• Strong-form EMH - prices reflect all public
and private information
 Weak-Form EMH
• Current prices reflect all security-market
information, including the historical
sequence of prices, rates of return, trading
volume data, and other market-generated
information
• This implies that past rates of return and
other market data should have no
relationship with future rates of return
• Trend analysis & similar methods are
useless
 Semistrong-Form EMH
• The semistrong hypothesis encompasses the
weak-form hypothesis,
• Current security prices reflect all public
information, including market and non-
market information such as earnings and
dividend announcements, price-to-earnings
(P/E) ratios, dividend-yield (D/P) ratios,
price-book value (P/BV) ratios, stock splits,
news about the economy, and political
news, product lines, accounting data,
financial data
 Semistrong-Form EMH
• This implies that decisions made on new
information after it is public should not lead
to above-average risk-adjusted profits from
those transactions because the security price
should immediately reflect all such new
public information.
 Strong-Form EMH
• The strong-form EMH encompasses both
the weak-form and the semistrong-form
EMH
• Stock prices fully reflect all information
from public and private sources (insiders)
• This implies that no group of investors
should be able to consistently derive above-
average risk-adjusted rates of return
• This assumes perfect markets in which all
information is cost-free and available to
everyone at the same time
 What all this mean
• If markets are weak form efficient, then technical
analysis has no merit (search for predictable
patterns in stock prices)
• If markets are semi-strong efficient then
fundamental analysis is also useless (careful study
of companys financial, its micro & macro
economics ,past earnings, competative
environment to forcast future performance of
firm)
– The only way to reap benefit from fundamental
analysis is if your analysis is better than ur competitors.
(y it would be better when all have same info in the
market)
• in efficient markets, a portfolio manager
who utilises active strategies cannot
outperform his counterpart who utilises
passive strategies, after transaction costs.
 Behavioral Finance
It is concerned with the analysis of various
psychological traits of individuals and how
these traits affect the manner in which they
act as investors, analysts, and portfolio
managers
 defination
• “seeks to understand and predict systematic
financial market implications of
psychological decisions processes …
behavioral finance is focused on the
implication of psychological and economic
principles for the improvement of financial
decision-making.”
 three tributaries that form the
river of behavioral finance
1. psychology that focuses on individual
behavior,
2. social psychology, which is the study of
how we behave and make decisions in the
presence of others
3. neurofinance, which is the anatomy,
mechanics, and functioning of the brain.
Twofold emphasis on behavioral
finance
• First, on identifying portfolio anomalies
that can be explained by various
psychological traits in individuals
• second, identifying groups or pinpointing
instances when it is possible to experience
above-normal rates of return by exploiting
the biases of investors, analysts, or portfolio
managers.
 Explaining Biases
• investors have a number of biases that
negatively affect their investment
performance.
1.propensity of investors to hold on to
“losers” too long and sell “winners” too
soon. Apparently, investors fear losses
much more than they value gains—a
tendency toward loss aversion.
2. belief perseverance, which means that
once people have formed an opinion (on a
company or stock) they cling to it too
tightly and for too long. As a result, they
are reluctant to search for contradictory
beliefs, and even when they find such
evidence, they are very skeptical about it
or even misinterpret such information.
3. anchoring, wherein individuals who are
asked to estimate something, start with an
initial arbitrary (casual) value and then
adjust away from it. The problem is that
the adjustment is often insufficient.
Therefore, if your initial estimate is low,
you may raise it with information, but it is
likely you will not raise it enough and thus
will still end up below the “best
estimates.”
4. Overconfidence, in forecasts, which
causes analysts to overestimate the rates of
growth and its duration for growth
companies and overemphasize good news
and ignore negative news for these firms.
5. representativeness, which causes them to
believe that the stocks of growth
companies will be “good” stocks.
6. confirmation bias, whereby investors
look for information that supports prior
opinions and decisions they have made.
7. self-attribution bias where people have a
tendency to ascribe any success to their
own talents while blaming any failure on
“bad luck,” which causes them to
overestimate their talent
8. hindsight bias, which is a tendency after
an event for an individual to believe that
he or she predicted it, which causes people
to think that they can predict better than
they can.
9. escalation bias, which causes investors to
put more money into a failure that they
feel responsible for rather than into a
success. refer to a situation in which
people who have initially made a decision
that may be rational, follow it up with an
irrational one in order to justify the initial
• follow the herd biase follow noise trader
•Noise trader is generally a term used to
describe investors who make decisions
regarding buy and sell trades without the
support of professional advice or advanced
fundamental analysis. ... These investors
typically follow trends and overreact to good
and bad news.
 Fusion Investing
• Fusion investing is a relatively new approach that
attempts to integrate traditional and behavioral
paradigms to create more
robust investment models.
• fusion investing is the integration of two elements
of investment valuation—fundamental value and
investor sentiment.
• Under this combination pricing model of fusion
investing, investors will engage in fundamental
analysis but also should consider investor
sentiment in terms of fads and fashions.
 Fusion Investing
• During some periods, investor sentiment is rather
muted and noise traders are inactive, so that
fundamental valuation dominates market returns.
• In other periods, when investor sentiment is
strong, noise traders are very active and market
returns are more heavily impacted by investor
sentiments.
 Implications of
Efficient Capital Markets
• Overall results indicate the capital markets are
efficient as related to numerous sets of
information
• At the same time,There are substantial instances
where the market fails to rapidly adjust to public
information
• Given these mixed results regarding the existence
of efficient capital markets, it is important to
consider the implications of this contrasting
evidence of market efficiency
 Efficient Markets
and Technical Analysis
• Assumptions of technical analysis directly
oppose the notion of efficient markets
• Technicians believe that new information is
not immediately available to everyone, but
disseminated from the informed
professional first to the aggressive investing
public and then to the masses
 Efficient Markets
and Technical Analysis
• Technicians also believe that investors do
not analyze information and act
immediately - it takes time
• Therefore, stock prices move to a new
equilibrium after the release of new
information in a gradual manner, causing
trends in stock price movements that persist
for periods
 Efficient Markets
and Technical Analysis
• Technical analysts believe that nimble
traders can develop systems to detect the
beginning of a movement to a new
equilibrium (called a “breakout”). Hence,
they hope to buy or sell the stock
immediately after its breakout to take
advantage of the subsequent, gradual price
adjustment.
 Efficient Markets
and Technical Analysis
• This Contradicts rapid price adjustments indicated
by the EMH
• If the capital market is weak-form efficient, a
trading system that depends on past trading data as
per analysist can have no value.
• By the time the information is public, the price
adjustment has taken place. Therefore, a purchase
or sale using a technical trading rule should not
generate abnormal returns after taking account of
risk and transaction costs.
 Efficient Markets
and Fundamental Analysis
• Fundamental analysts believe that there is a
basic intrinsic value for the aggregate stock
market, various industries, or individual
securities and these values depend on
underlying economic factors
• Investors should determine the intrinsic
value of an investment at a point in time
and compare it to the market price
• If the prevailing market price differs from
the estimated intrinsic value by enough to
cover transaction costs, you should take
appropriate action:
• You buy if the market price is substantially
below intrinsic value
• you sell, if the market price is above the
intrinsic value.
• Investors who are engaged in fundamental
analysis believe that, occasionally, market
price and intrinsic value differ but
eventually investors recognize the
discrepancy and correct it.
 Efficient Markets
and Fundamental Analysis
• If you can do a superior job of estimating
intrinsic value you can make superior
market timing decisions and generate
above-average returns
• This involves aggregate market analysis,
industry analysis, company analysis, and
portfolio management
• Intrinsic value analysis should start with
aggregate market analysis
 Aggregate Market Analysis with
Efficient Capital Markets
• EMH implies that examining only past economic
events is not likely to lead to outperforming a buy-
and-hold policy because the market adjusts rapidly
to known economic events
• Merely using historical data to estimate future
values is not sufficient
• You must estimate the relevant variables that
cause long-run movements
• AGGREGATE MARKET ANALYSIS:
An investigation of macroeconomic
phenomena, including unemployment,
inflation, business cycles, and stabilization
policies, using the aggregate
market interactionbetween aggregate
demand, short-run aggregate supply, and
long-run aggregate supply.
• Aggregate demand is an economic measurement
of the sum of all final goods and services
produced in an economy, expressed as the total
amount of money exchanged for those goods and
services.
• Aggregate supply, also known as total output, is
the total supply of goods and services produced
within an economy at a given overall price level in
a given period. ...
• AGGREGATE MARKET: An economic model
relating the price level and real production(GDP)
that is used to analyze business cycles, gross
production, unemployment, inflation, stabilization
policies, and related macroeconomic phenomena.
 Industry and Company Analysis
with Efficient Capital Markets
• Wide distribution of returns from different
industries and companies justifies industry
and company analysis
• However EME implies that you
1.Must understand the variables that effect
rates of return and
2.Do a superior job of estimating future
values of these relevant valuation variables,
not just look at past data
• Analyst in past developed a model that did an excellent job
of explaining past stock price movements using historical
data. When this valuation model was employed to project
future stock price changes using past company data,
however, the results were consistently inferior to a buyand-
hold policy.

• This implies that, even with a good valuation model, you

cannot select stocks that will provide superior future
returns using only past data as inputs.

• The point is, most analysts are aware of the several well-
specified valuation models, so the factor that differentiates
superior from inferior analysts is the ability to provide
more accurate estimates of the critical inputs to the
valuation models and be different from the consensus.
 Industry and Company Analysis
with Efficient Capital Markets
• Important relationship exist between expected
earnings and actual earnings
• Accurately predicting earnings surprises as stock
prices increased if actual earnings substantially
exceeded expected earnings and stock prices fell if
actual earnings were below expected levels.
• Strong-form EMH indicates likely existence of
superior analysts
• Studies indicate that fundamental analysis based
on p/e ratios, size, and the BV/MV ratios can lead
to differentiating future return patterns
 How to Evaluate Analysts or
Investors
• Examine the performance of numerous
securities that this analyst recommends over
time in relation to a set of randomly
selected stocks in the same risk class
• Selected stocks should consistently
outperform the randomly selected stocks
 Efficient Markets
and Portfolio Management
• Should a portfolio be managed actively or passively?
• how to manage the portfolio (actively or passively)
depends on whether the manager (or an investor) has
access to superior analysts.
• A portfolio manager with superior analysts or an investor
who believes that he or she has the time and expertise to be
a superior investor can manage a portfolio actively by
looking for undervalued or overvalued securities and
trading accordingly.
• In contrast, without access to superior analysts or the time
and ability to be a superior investor, you should manage
passively and assume that all securities are properly priced
based on their levels of risk
 Efficient Markets
and Portfolio Management
• Portfolio Managers with Superior Analysts
• A portfolio manager with access to superior
analysts who have unique insights and analytical
ability should follow their recommendations.
• The superior analysts should make investment
recommendations for a certain proportion of the
portfolio, and the portfolio manager should ensure
that the risk preferences of the client are
maintained.
 Efficient Markets
and Portfolio Management
• Portfolio Managers with Superior Analysts
– concentrate efforts in mid-cap stocks that do
not receive the attention given by institutional
portfolio managers to the top-tier stocks
– the market for these neglected stocks may be
less efficient than the market for large well-
known stocks
 Efficient Markets
and Portfolio Management
• New information on top-tier stocks is well publicized and
rigorously analyzed so the price of these securities should
adjust rapidly to reflect the new information.
• In contrast, mid-cap and small-cap stocks receive less
publicity and fewer analysts follow these firms, so prices may
differ from intrinsic value for one of two reasons.
• First, because of less publicity, there is less information
available on these firms.
• Second, there are fewer analysts following these firms so the
adjustment to the new information is slowed.
• Therefore, the possibility of finding temporarily undervalued
securities among these neglected stocks is greater
 Efficient Markets
and Portfolio Management
• Portfolio Managers without Superior
Analysts should
– Determine and quantify your client's risk
preferences
– Construct the appropriate portfolio to match
risk level by investing a certain proportion of
the portfolio in risky assets and the rest in a
risk-free asset,
– Diversify completely on a global basis to
eliminate all unsystematic risk
 Efficient Markets
and Portfolio Management
– Maintain the desired risk level by rebalancing
the portfolio whenever necessary
– Minimize total transaction costs
• Three factors are involved in minimizing total transaction
costs:
• 1. Minimize taxes
• 2. Reduce trading turnover. Trade only to sell overvalued
stock out of the portfolio or add undervalued stock while
maintaining a given risk level.
• 3. When you trade, minimize liquidity costs by trading
relatively liquid stocks.
Insights from Behavioral Finance
• Growth companies will usually not be
growth stocks due to the overconfidence of
analysts regarding future growth rates and
valuations
• Notion of “herd mentality” of analysts in
stock recommendations or quarterly
earnings estimates is confirmed
 Few market terms
1) A bull market is a market that is on the rise and is a
bear market is a market that is receding, where most
stocks are declining in value. Although some investors
are "bearish," the majority of investors are "bullish.
A bull thrusts its horns up into the air, while
a bear swipes its paws downward. These actions are
metaphors for the movement of a market.

2) Arbitrage refers to buying and selling the same security

on different markets and at different price points. For
instance, if stock XYZ is trading at $10 on one market and
$10.50 on another, the trader could buy X shares for $10
and sell them for $10.50 on the other market, pocketing
the difference.
3) Blue Chip Stocks offer a stable record of significant
dividend payments and have a reputation of sound fiscal
management. Stocks of best performing firms.

4) haircut is an extremely thin spread between the bid and

ask prices of a given stock.

5) A rapid increase in the general price level of the market

or of the price of a stock is known as a rally.

6(Volatility The price movements of a stock or the stock

market as a whole
7) Speculators are sophisticated investors or traders who
purchase assets for short periods of time and employ
strategies in order to profit from changes in its
price. Speculators are important to markets because they
bring liquidity and assume market risk