What is an Efficient Financial Market?

1. What is an Efficient Financial Market? An efficient market is a market in which all the available information is “fully reflected” by the prices of the securities. Very useful concept: Like Physics in the absence of frictions. Like all good theories it is clearly false.

2. Opportunities Arise From Inefficiencies • Portfolio managers look for investment opportunities, e.g., underpriced stock. • Corporate treasurers look for financing opportunities, e.g., cheap sources of capital. Neither of these activities make sense if markets are perfectly efficient. To understand either of these activities, we need to develop theories of inefficient markets.

3. Theories of Inefficient Markets • Incentives of institutional investors • Behavioral biases

4. Institutional Incentives • Institutions evaluate managers on the success of individual stock picks • Makes the managers sensitive to diversifiable risk • Institutional markets are segmented • Suggests the possibility of shortages and surpluses of capital in various asset classes • Institutions are evaluated based on performance relative to a benchmark • Implies that the relevant risk is tracking error

5. Yahoo’s addition to the S&P 500 index was announced on December 1st 1999 after the closing of the market. The effective addition date was December 8th 1999. The following Graphs show the behavior of the stock in the first two weeks of December.

6. Yahoo’s stock price response to its addition to the S&P 500

7. How do Hedge Funds Take Advantage of Institutional Biases? • Convertible Hedge Funds • Exploits the relative shortage of institutional money available to invest in convertibles relative to corporate demand for this form of financing. • Distress debt Hedge Funds • Exploits the relative shortage of institutional money available to invest in distressed debt relative to its availability in recessions. • Merger arbitrage Hedge Funds • Exploits the risk aversion of portfolio managers that hold target shares

8. Behavioral Biases • Overconfidence • Consistent with evolutionary theories • Overconfident men are more likely to pass on their genes • Experimental evidence of overconfidence • Most people believe that they are better than average drivers • Doctors overestimate the probability that their diagnoses are correct • Men are more overconfident than women

9. How does overconfidence influence investor behavior? • Investors trade too much • Investors put too much weight on information they collect on their own and too little weight on information that is provided by others • Loss aversion – investors are reluctant to sell past losers and admit that they made a mistake.

10. Inefficiencies that relate to overconfidence • Underreaction to corporate disclosures • Stock prices appear to underreact to capital structure changes, earnings announcements, stock splits etc. • Overreaction to “intangible” information • Stock price changes that cannot be tied to fundamentals partially reverse • Momentum

11. Underreaction to Corporate Disclosures • Dividend Announcements • Share repurchases • Share Issuances In general, leverage increasing events are viewed as good news and leverage decreasing events are viewed as bad news. Historically, the market has underreacted to this information. Explanation: Overconfident investors think they know the information already.

12. Momentum and Reversals • Returns patterns over 3 to 12 months tend to continue. • Winners keep winning and losers keep losing. • More pronounced for growth stocks • More pronounced for small stocks • Over 3 to 5 year periods, return patterns tend to reverse. • Returns that are associated with changes in fundamentals (i.e., tangible information) do not seem to reverse. • Returns that are not associated with changes in fundamentals (perhaps, responding to intangible information) tend to reverse.

13. Disclaimer • Investors are now well aware of these institutional are behavioral biases • Do we expect the apparent inefficiencies to be eliminated?

14. “Apparent” Profit Opportunities • Strategies with high probabilities of realizing modest excess returns with low probabilities of realizing extremely high negative returns. • Out of the money calls and puts • Earthquake insurance • Doubling strategies • Funds that follow these strategies may appear to beat the market for a number of years, and then suddenly “blow up.”