Issues with EMH
EMH does not arise enthusiasm in the
community of professional portfolio managers
The Magnitude Issue
Small contributions that can increase investment earnings by millions
would be swamped by the yearly volatility of the market
The Selection Bias Issue
We cannot fairly evaluate the true ability of portfolio managers to
generate winning stock market strategies
The Lucky Event Issue
If many investors using a variety of schemes make fair bets,
statistically speaking, some of those investors will be lucky and win a
great majority of the bets
Test of Predictability in Stock Market
Returns
Returns over Short Horizons
Positive Serial Correlation (Conrad and Kaul, Lo and
MacKinlay)
Serial Correlation refers to the tendency for stock returns to be related.
Positive Serial Correlation means that positive returns tend to follow
positive returns
Filter Rule
A filter technique gives a rule for buying or selling a stock depending on
past price movements
Ex: “Buy if the last two trades each resulted in a stock price increase.”
Returns Over Long Horizons
“fads hypothesis” which asserts that stock prices might overreact to relevant
news. Such overreaction leads to positive serial correlation.
Test of Predictability in Stock Market
Returns (Cont’d)
Predictors of Broad Market Returns:
Several studies have documented the ability of
easily observed variables to predict market
returns
Fama and French showed that the return on the aggregate
stock market tends to be higher when the dividend/price ratio,
the dividend yield, is high
Campbell and Shiller found that the earnings yield can predict
market returns
Keim and Stambaugh showed that bond market data such as
the spread between yields on high- and low-grade corporate
bonds also help predict broad market returns
Fundamental Analysis vs. Technical
Analysis
Returns over Short Horizons
Fundamental analysis calls on a much wider range of
information to create portfolios than does technical analysis
Tests of the value of fundamental analysis are more difficult to
evaluate
Technical analysis focuses on stock price patterns and on
proxies for buy or sell pressure in the market. Fundamental
analysis focuses on the determinants of the underlying value of
the firm, such as current profitability and growth prospects
Investors must choose between the two approaches
depending on their needs
However, a number of so-called anomalies have been revealed
(evidence that seems inconsistent with the efficient market
hypothesis)
Market Anomalies
P/E Effect
Uses P/E ratio to find the value of stocks
Sometimes and after adjusting for risk, low P/E stocks
outperform high P/E stocks
Small-Firm in January Effect
Stocks returns can be directly tied to the time (of year or
week)
Some Examples include:
January effect
weekend effect
The size of firms will affect the returns of stocks
Sometimes and after adjusting for risk, small firms offer
higher returns than large firms
Market Anomalies (cont’d)
The Neglected Firm Effect
Because small firms tend to be neglected by large
institutional traders, information about smaller firms is less
available. This information deficiency makes smaller firms
riskier investments that command higher returns
Post Earnings Announcements Price Drift
Sometimes price adjustments of stocks continue after
earnings adjustments have been declared
Identifying buying opportunities may be done when unusual
good quarterly earnings are reported
Behavioral Interpretation
Psychologists have identified several “irrationalities”
that seem to characterize individuals
Forecasting errors: people give too much weight to recent
experience compared to prior beliefs when making forecasts,
and tend to make forecasts that are too extreme given the
uncertainty inherent in their information
Overconfidence: People tend to underestimate the imprecision
of their beliefs or forecasts, and they tend to overestimate their
abilities
Regret avoidance: Psychologists have found that individuals
who make decisions that turn out badly have more regret when
that decision was more unconventional
Are Markets Efficient?
An overly doctrinaire belief in efficient markets can paralyze the
investor and make it appear that no research effort can be
justified. This extreme view is probably unwarranted. There are
enough anomalies in the empirical evidence to justify the
search for underpriced securities that clearly goes on.
However, evidence suggests that the market is competitive
enough that only differentially superior information or insight
will earn money
In the end it is likely that the margin of superiority that any
professional manager can add is so slight that the statistician
will not easily be able to detect it.
We conclude that markets are very efficient, but that rewards
may in fact take time