Stock Market Efficiency: Alternative Views

1. Stock Market Efficiency: Alternative Views Corporate Finance 27

2. Stock market efficiency: alternative views • Views of professional investors • Whether stock markets appear to absorb all relevant (public or private) information (strong-form efficiency) • The behavioural-based arguments leading to a belief in inefficiencies • The implications of the evidence for efficiency for investors and corporate management

3. Comment on the semi-strong efficiency evidence • Despite the evidence of some work showing departures from semi-strong efficiency, for most investors most of the time the market may be regarded as efficient • The evidence for semi-strong efficiency is significant but not so overwhelming that there is no hope of outperformance for the able and dedicated • Publication bias • Hundreds of researchers examining the data • A lot of evidence of inefficiency that remains hidden • Paradox: in order for the market to remain efficient there has to be a large body of investors who believe it to be inefficient

4. The views of some successful investors • Peter Lynch • Quantitative analysis taught me that the things I saw happening at Fidelity couldn’t really be happening. I also found it difficult to integrate the efficient market hypothesis… It also was obvious that the Wharton professors who believed in quantum analysis and random walk weren’t doing nearly as well as my new colleagues at Fidelity • John Neff • Always on the lookout for out-of-favour, overlooked or misunderstood stocks • He believes that the market tends to allow itself to be swept along with fads, fashions and flavours of the month. This leads to overvaluation of those stocks regarded as shooting stars, and to the undervaluation of those which prevailing wisdom deems unexciting, but which are fundamentally good stocks

5. The views of some successful investors • Benjamin Graham • ‘The prices of common stock are not carefully thought out computations,but the resultants of a welter of human reactions. The stock market is a voting machine rather than a weighing machine’ • The processes by which the securities market arrives at its appraisals are frequently illogical and erroneous. These processes . . . are not automatic or mechanical, but psychological for they go on in the minds of people who buy and sell. The mistakes of the market are thus the mistakes of groups of masses of individuals. Most of them can be traced to one or more of three basic causes: exaggeration, oversimplification, or neglect

6. The views of some successful investors • Warren Buffett and Charles Munger • I’m convinced that there is much inefficiency in the market . . . When the price of a stock can be influenced by a ‘herd’ on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical . . . There seems to be some perverse human characteristic that likes to make easy things difficult. The academic world, if anything, has actually backed away from the teaching of value investing over the last 30 years. It’s likely to continue that way. Ships will sail around the world but the Flat Earth Society will flourish

7. Strong-form tests • It is possible to trade shares on the basis of information not in the public domain and make abnormal profits • Trading on inside knowledge is thought to be a ‘bad thing’ • Insider dealing is considered to be, besides dealing for oneself either counselling or procuring another individual to deal in the securities or communicating knowledge to any other person, while being aware that he or she (or someone else) will deal in those securities • The term ‘insider’ covers anyone with sensitive information, not just a company director or employee • Raise the level of information disclosure • Prohibit certain individuals from dealing in the company’s shares for crucial time periods

8. Behavioural finance • Behavioural finance proponents argue that investors frequently make systematic errors and these errors can push the prices of shares away from fundamental value for considerable periods • Behavioural finance models offer plausible reasoning for the phenomena we observe in the pattern of share prices • They offer persuasive explanations for the outperformance of low PER,high dividend yield and low book-to-market ratio shares as well as the poor performance of ‘glamour’shares • They also shed light on both return reversal and momentum effects, stock market bubbles and irrational pessimism

9. The three lines of defence for EMH 1 Investors are rational and hence value securities rationally 2 Even if some investors are not rational, their irrationally inspired trades of securities are random and therefore the effects of their irrational actions cancel each other out without moving prices away from their efficient level 3 If the majority of investors are irrational in similar ways and therefore have a tendency to push security values away from the efficient level this will be countered by rational arbitrageurs who eliminate the influence of the irrational traders on prices

10. Arbitrage • Arbitrage is the act of exploiting price differences on the same security or similar securities by simultaneously selling the overpriced security and buying the underpriced security • Perfect arbitrage: a profit without any risk at all (and even without money) • To be effective the arbitrageur needs to be able to purchase or sell a close-substitute security • For example you discover that Unilever’s shares are undervalued • The risk of other fundamental factors influencing the shares of Unilever and P&G • The risk that the irrational investors push irrationality to new heights • ‘Risk arbitrage’ and risk-free arbitrage

11. Some cognitive errors made by investors • The combination of limited arbitrage and investor sentiment pushing the market leads to inefficient pricing • Both elements are necessary • Overconfidence • Representativenes • Conservatism • Narrow framing • Ambiguity aversion

12. Some cognitive errors made by investors (continued) • Positive feedback and extrapolative expectations • Regret • Confirmation bias • Cognitive dissonance • Availability bias • Miscalculation of probabilities • Anchoring

13. Misconceptions about the efficient market hypothesis 1 Any share portfolio will perform as well as or better than a special trading rule designed to outperform the market 2 There should be fewer price fluctuations 3 Only a minority of investors are actively trading, most are passive, therefore efficiency cannot be achieved

14. Implications of the EMH for investors 1 For the vast majority of people public information cannot be used to earn abnormal returns 2 Investors need to press for a greater volume of timely information 3 The perception of a fair game market could be improved by more constraints and deterrents placed on insider dealers

15. Implications of the EMH for companies 1 Focus on substance, not on short-term appearance 2 The timing of security issues does not have to be fine- tuned 3 Large quantities of new shares can be sold without moving the price 4 Signals from price movements should be taken seriously

16. Concluding comments • Sophisticated stock markets are substantially efficient • Question the assumption that all investors respond in a similar manner to the same risk and return factors and that these can be easily identified • One way of ‘outperforming’ the market might be to select shares the attributes of which you dislike less than the other investors • Another way is through luck • Possessing superior analytical skills • Through the discovery of a trading rule which works • To be quicker than anyone else • To become an insider

17. Lecture review • Strong-form efficiency • Insider dealing • Behavioural finance studies • Implications of the EMH for investors • Implications of the EMH for companies