Market Efficiency Study Guide & Cheat Sheet
Efficient Market Hypothesis (EMH)
Core Concept: No one can consistently beat the market without taking additional risk.
Key Principles:
Stock prices fully reflect all information and accurately reflect fundamentals
Analysis of historical or new information is useless
No arbitrage is possible
Fund manager "skills" do not matter
Three Forms of EMH
1. Weak Form
Stock prices reflect all past trading information, but not new information
Technical analysis is useless
2. Semi-Strong Form
Stock prices reflect all new, publicly available information, but not inside information
Front-running and fundamental analysis are useless
3. Strong Form
Stock prices reflect ALL information including inside information
Even insider trading becomes useless
Random Walk Theory (Burton Malkiel)
Stock prices follow a random walk process
Cannot consistently beat the market
Technical and fundamental analysis don't lead to better results
Passive strategy (buy and hold index fund) works best long-term
How Market Efficiency Works (3-Step Process)
Step 1: Investors collect information
Problem: Information asymmetry and information costs
Step 2: Investors analyze information and identify mispriced stocks
Undervalued: stock price < intrinsic value → buy
Overvalued: stock price > intrinsic value → sell/short
Problem: Information uncertainty
Step 3: Investors trade until mispricing disappears
Stock prices fully reflect all available information
Problems: Transaction costs, behavioral biases
Key Concepts & Theories
Arbitrage
Exploiting price differences for identical assets
Example: Bank A (1 USD = 1.3 CAD) vs Bank B (1 USD = 1.2 CAD)
Buy CAD from A, sell to B for profit
In efficient markets, arbitrage opportunities disappear quickly
Samuelson's Dictum
"Micro efficient" but "macro inefficient"
Individual stocks tend to be priced accurately relative to each other
Market as a whole is not always efficiently priced
Over time: bubbles and crashes occur
Grossman-Stiglitz Paradox
If market too efficient → no one collects information → market becomes less efficient
If market too inefficient → high returns from research → more people collect info → market becomes more
efficient
Dynamic equilibrium: market never too efficient nor too inefficient
Limits to Market Efficiency
1. Information Costs
Information asymmetry (managers strategically manage disclosure)
Database subscriptions are costly
Time costs for collecting and analyzing information
Investors only collect info until marginal return = marginal cost
2. Information Uncertainty
Same information leads to different conclusions
Earnings info and takeover rumors are highly uncertain
Model risk in equity analysis
3. Transaction Costs (Limits to Arbitrage)
Fundamental risk: Future dividends may be lower/higher than expected
Idiosyncratic risk: Mispricing could become more severe tomorrow
Other costs: Bid-ask spread, commissions, taxes
4. Behavioral Biases
Disposition Effect (Prospect Theory)
Tendency to sell assets that increased in value
Reluctance to sell assets that dropped in value
Often irrational behavior
Attention Effect
Investors buy stocks that recently attracted attention (news, analyst recommendations, extreme price
movements)
These stocks tend to have lower future returns
Overconfidence (Lake Wobegon Effect)
"All the women are strong, all the men are good looking, and all the children are above average"
Barber and Odean (2001): Men trade 45% more than women
Men's returns reduced by 2.65% per year vs 1.72% for women
Over-trading reduces wealth significantly
Memory Bias
Give too much weight to recent experience
Don't learn from earlier lessons (bubbles)
History repeats itself
Conservatism
Update beliefs insufficiently when presented with new information
Sentiment
Affected by: day vs night, sunny vs rainy, summer vs winter, recent experience/mood
Market sentiment indicators: #IPOs, mutual fund flows, retail investor trades, first-day IPO returns, M&As
Negatively associated with future returns
Hirshleifer and Shumway (2003): Sunshine significantly correlated with returns
Market Anomalies (Contradictions to EMH)
Fama-French Three Factors
1. Market Factor ("Beta")
The beta in CAPM
2. Size Effect (SMB - Small Minus Big)
Small-cap firms tend to outperform large-cap firms
Robust anomaly
3. Value Effect (HML - High Minus Low)
High book-to-market ratio firms (value firms) outperform low book-to-market firms (growth firms)
Robust anomaly
Other Anomalies
January Effect
Stock returns abnormally high in January
Primarily observed in small stocks
Possible reasons: Tax-sensitive individual investors, year-end bonus
Momentum and Reversal
Past winners continue to outperform for up to 6 months
Past losers continue to underperform for up to 6 months
After ~6 months, patterns reverse
Negative momentum/reversal over long horizons
Low-Volatility Anomaly
Portfolios of low-volatility stocks have higher risk-adjusted returns than high-volatility portfolios
Contradicts pricing theories (low volatility should = lower returns)
Post Earnings Announcement Drift (PEAD)
Stock prices continue to drift after earnings announcements
Insider Trading
Seyhun (1987): Insiders can profit from trading on non-public information
Market Bubbles & Crashes
Definition
Asset prices clearly higher than intrinsic values
Characteristics
Bubbles per se don't hurt economy; crashes after uncontrollable bubbles do
Most bubbles occur in financial markets (assets priced relative to each other based on expectations)
Famous Historical Bubbles
Tulipomania
South Sea Bubbles
Crash of 1929
Bitcoin 2017-2018
The Greater Fool Theory
"You can profit from buying overpriced stocks as long as you can sell to 'a greater fool'"
Explains why investors keep buying in bubbles
Buying in a bubble may be more profitable than rational short sale strategy (while bubble grows)
Notable Quote
Sir Isaac Newton (lost 20,000 GBP in South Sea Bubble): "I can calculate the movement of the stars, but not
the madness of men."
Investment Strategies
Active Strategies (if market sufficiently inefficient)
Technical analysis
Fundamental analysis
Passive Strategies (if market sufficiently efficient)
Buy low expense ratio market index fund
Hold for long time
Mixed Strategies
Buy mutual funds and manage capital allocations
Technical Analysis
Definition: Attempt to exploit recurring and predictable patterns in stock prices (contradicts weak form EMH)
Technicians' Beliefs
Shifts in market fundamentals can be discerned before fully reflected in prices
Market fundamentals can be perturbed by irrational factors
Key Concepts
Dow Theory: Primary, secondary/intermediate, and tertiary/minor trends
Support and resistance levels: Price levels where stocks tend to stop falling or rising
Moving averages: 200-day or 50-day averages; crossing predicts direction change
Other indicators: Bollinger bands, MACD, volume
Limitations
Popular in many countries
Works for some people, not others
Self-destructing patterns: Explains the past, can't predict the future
Pygmalion Effect (self-fulfilling): If many believe and trade accordingly, analysis works temporarily, but
patterns eventually fail
Evidence: Is the Market Efficient?
Supporting Efficiency
High risk, high return relationship
Technical analysis isn't generally effective
Not many arbitrage opportunities
Most people cannot beat the market
Supporting Inefficiency
Market anomalies (some stocks have higher returns without greater risk)
Market bubbles and crashes
Super investors
Insider trading profits
The Dartboard Contest (1988 WSJ)
Four financial experts vs dartboard picks
Experts generally won
Flawed design:
Experts pick riskier stocks (high risk, high return)
Even if monkeys won, doesn't prove efficiency
Important Examples
Sahara Free Ace Coupon (Pontiff 2006)
Blackjack coupon with 41.5% NPV
No one wants to all-in bet
Conclusion: People care about idiosyncratic risk even when they can diversify
Long-Term Capital Management (LTCM)
Hedge fund arbitraging fixed income products
Leaders included Nobel Laureates Myron Scholes and Robert Merton
Arbitraged "on the run" vs "off the run" treasury bonds
Spread widened after Asian crisis defaults
Required bailout
Key Quotes
"Buy Low, Sell High" - Basic investment principle
"There's no asset so good that it can't be overpriced and become a bad investment, and very few assets
are so bad they can't be underpriced and be a good investment." - Howard S. Marks
Economist Joke: Two economists see a $20 bill on sidewalk. One starts to pick it up, other says: "Don't bother;
if the bill were real someone would have picked it up already."
Lesson: If everyone believes market is perfectly efficient, arbitrage opportunities will remain. If you see an
opportunity, go for it (while managing risk).
Exam Tips & Key Takeaways
1. Know all three forms of EMH and what type of analysis is useless in each
2. Understand the 3-step efficiency process and problems at each step
3. Memorize Fama-French three factors (market, size, value)
4. Know major behavioral biases and real-world examples
5. Understand Samuelson's Dictum (micro efficient, macro inefficient)
6. Remember Grossman-Stiglitz Paradox (dynamic equilibrium concept)
7. Know major anomalies and what they contradict
8. Understand limits to arbitrage (fundamental risk, idiosyncratic risk, other costs)
9. Greater Fool Theory explains bubble behavior
10. Evidence is mixed: market has both efficient and inefficient characteristics