Personal Investment Management
ADMS 3531 Fall 2011 – Professor Dale Domian
Lecture 6 – Stock Price Behaviour and Market Efficiency – Oct 25
Chapter 8 Outline
Introductions to market efficiency.
What does ‘beat the market’ mean?
Foundations of market efficiency.
Forms of market efficiency.
Why would a market be efficient?
Some implications of market efficiency.
Informed traders and inside trading
How efficient are markets?
Market efficiency and the performance of professional money managers.
Bubbles and crashes.
Tests of different types of market efficiency.
Controversy, Intrigue, and Confusion
We being by asking a basic question – Can you, as an investor, consistently ‘beat the
It may surprise you to learn that evidence strongly suggests that the answer to this
question is ‘probably not’.
We show that even professional money managers have trouble beating the market.
At the end of the chapter, we describe some market phenomena that sound more like
carnival side shows, such as ‘the amazing January effect’.
The efficient market hypothesis (EMH) is a theory that asserts: as a practical matter, the
major financial markets reflect all relevant information at a given time.
Market efficiency research examines the relationship between stock prices and available
o The important research question – Is it possible for investors to ‘beat the market’?
o Prediction of the EMH theory – If a market is efficient, it is not possible to ‘beat
the market’ (except by luck). What Does ‘Beat the Market’ Mean?
The excess return on an investment is the return in excess of that earned by other
investments that have the same risk.
‘Beating the market’ means consistently earning a positive excess return.
Three Economic Forces that Can Lead to Market Efficiency
Investors use their information in a rational manner.
o Rational investors do not systematically overvalue or undervalue financial assets.
o If every investor always makes perfectly rational investment decisions, it would
be very difficult to earn an excess return.
There are independent deviations from rationality.
o Suppose that many investors are irrational.
o The net effect might be that these investors cancel each other out.
o So, irrationality is just noise that is diversified away.
o What is important here is that irrational investors have different beliefs.
o Suppose collective irrationality does not balance out.
o Suppose there are some wellcapitalized, intelligent, and rational investors.
o If rational traders dominate irrational traders, the market will still be efficient.
Forms of Market Efficiency
A weakform efficient market is one in which past prices and volume figures are of no
use in beating the market.
o If so, then technical analysis is of little use.
A semi strongform efficient market is one in which publicly available information is of
no use in beating the market.
o If so, then fundamental analysis is of little use.
A strongform efficient market is one in which information of any kind, public or private,
is of no use in beating the market.
o If so, then ‘inside information’ is of little use.
Why Would a Market be Efficient?
The driving force toward market efficiency is simply competition and the profit motive.
Even a relatively small performance enhancement can be worth a tremendous amount of
money (when multiplied by the dollar amount involved).
This creates incentives to unearth relevant information and use it. Does Old Information Help Predict Future Stock Prices?
This is a surprisingly difficult question to answer clearly.
Researchers have used sophisticated techniques to test whether past stock price
movements help predict future stock price movements.
o Some researchers have been able to show that future returns are partly predictable
by past returns.
BUT – there is not enough predictability to earn an excess return.
o Also, trading costs swamp attempts to build a profitable trading system built on
o Result – Buy and hold strategies involving broad market indexes are extremely
difficult to outperform.
Random Walks and Stock Prices
If you were to ask people you know whether stock market prices are predictable, many of
them would say yes.
To their surprise it is very difficult to predict stock market prices.
In fact, considerable research has shown that stock prices change through time as if they
That is, stock price increases are about as likely as stock price decreases.
When there is no discernible pattern to the path that a stock price follows, then the stock’s
price behaviour is largely consistent with the notion of a random walk.
How New Information Gets into Stock Prices
In its semistrong form, the EMH states simply that stock prices fully reflect publicly
Stock prices change when traders buy and sell shares based on their view of the future
prospects for the stock.
But, the future prospects for the stock are influenced by unexpected news
Prices could adjust to unexpected news in three basic ways:
o Efficient market reaction – The price instantaneously adjusts to the new
o Delayed reaction – The price partially adjusts to the new information.
o Overreaction and Connection – The price overadjusts to the new information, but
eventually falls to the appropriate price.
Event Studies Researchers have examined the effects of many types of news announcements on stock
Such researchers are interested in:
o The adjustment process itself.
o The size of the stock price reaction to a news announcement.
To test for the effects of new information on stock prices, researchers use an approach
called an event study.
Informed Traders and Insider Trading
If a market is strongform efficient, no information of any kind, public or private, is
useful in beating the market.
But, it is clear that significant inside information would enable you to earn substantial
This fact generates an interesting question: Should any of us be able to earn returns based
on information that is not known to the public?
It is illegal to make profits on nonpublic information.
o It is argued that this ban is necessary if investors are to have trust in stock
o Securities exchange commissions enforce laws concerning illegal trading
It is important to be able to distinguish between:
o Informed trading.
o Legal inside trading.
o Illegal insider trading.
When an investor makes a decision to buy or sell a stock based on publicly available
information and analysis, this investor is said to be an informed trader.
The information that an informed trader possesses might come from:
o Reading journals.
o Reading quarterly reports issued by a company.
o Gathering financial information from the Internet.
o Talking to other investors.
Legal Insider Trading
Some informed traders are also insider traders.
When you hear the term insider trading, you most likely think that such activity is illegal. But, not all insider trading is illegal.
o Company insiders can make perfectly legal trades in the stock of their company.
o They must comply with the reporting rules made by the SEC.
o When company insiders make a trade and report it to the SEC, these trades are
reported to the public by the SEC.
o In addition, corporate insiders must declare that trades that they made were based
on public information about the company, rather than ‘inside’ information.
Who is an ‘Insider’?
For the purpose of defining i