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Are Financial Markets Efficient?

Are Financial Markets Efficient?. Overview of Presentation. What is meant by “market efficiency?” Why is market efficiency important? Is the stock market “efficient?” What does market efficiency imply about investing?. Disclaimer: I am not trying to sell you anything.

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Are Financial Markets Efficient?

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  1. Are Financial Markets Efficient?

  2. Overview of Presentation • What is meant by “market efficiency?” • Why is market efficiency important? • Is the stock market “efficient?” • What does market efficiency imply about investing?

  3. Disclaimer: I am not trying to sell you anything

  4. Disclaimer: I am not trying to sell you anything

  5. Disclaimer: I am not trying to sell you anything

  6. In 1990s, Dow went berserk! Dow Jones Industrial IndexMonthly Close, May 1949 - April 1999

  7. Don’t be amazed; we have been down this road before... • Dutch Tulip Bubble--17th century • South Sea Bubble -- 18th century • Florida Land Bubble -- 1920s • Great Bull Market of the 1920s

  8. Famous Last Words... “Stock prices have reached what looks like a permanently high plateau.” Professor Irving Fisher Yale University Early Autumn, 1929

  9. What is an Efficient Market? “A market is efficient with respect to information set if it is impossible to make economic profits by trading on the basis of information set .” Michael C. Jensen “Some Anomalous Evidence Regarding Market Efficiency.” Journal of Financial Economics 6 (1978): 95-101.

  10. Huh???? Translation: • after accounting for transactions and information costs, you can’t beat the market on a risk-adjusted basis.

  11. Some markets are amazingly efficient... • Returns on orange juice futures predicted the subsequent errors in temperature forecasts issued by the National Weather Service for the central Florida region where most juice oranges are grown. Richard Roll “Orange Juice and Weather.” American Economic Review 74 (1984): 861-880.

  12. Until recently, evidence strongly supported market efficiency… • Stock returns were unpredictable. • Stock prices rapidly reacted to new information (Event Studies). • Actively managed mutual funds turned in dismal records.

  13. Poor Record of Mutual Funds: An Example Suppose that at the start of 1969, you had invested $10,000 in an actively managed mutual fund and a Standard & Poor’s 500 Stock Index Fund. How much would these investments be worth thirty years later? Source: Burton G. Malkiel A Random Walk down Wall Street

  14. But, then troubling new evidence began to emerge... Pricing Anomalies • January Effect: January is great for stocks, especially small firm stocks. • Weekend Effect: Weekends are bad for stocks. • Mean Reversion:Today’s winners tend to be tomorrow’s losers and vice-versa.

  15. More Troubling Evidence: • Crash of October 19, 1987: Large correction with no apparent trigger. • Track record of “Superior Analysts:” Warren Buffett and Peter Lynch

  16. Perhaps, the most troubling puzzle: • Market efficiency implies brokers add no economic value. Yet, over the past 30+ years the number of brokers in the U.S has more than tripled.

  17. This new evidence has led to the rise of a new school of thought in academia... • Behavioralists

  18. Behavioralists believe: (1) Some investors are not fully rational and their demand for risky assets is affected by beliefs or sentiments not fully justified by fundamental news. (Noise Traders) (2)Arbitrage—defined as trading by fully rational investors not subject to such sentiment—is risky and therefore limited.

  19. Behavioralists conclude: • Assumptions (1) and (2) taken together imply changes in investor sentiment are not fully countered by arbitrageurs (and hence affect security returns). Andrei Shleifer and Lawrence H. Summers “The Noise Trader Approach to Finance.” Journal of Economic Perspectives 4, no. 2 (1990): 19-33.

  20. Implication of Behavioralism: • You can make money exploiting predictable patterns in securities prices.

  21. But wait…New evidence may not be fatal to efficient markets hypothesis: • “Bad Model” Problem:tests of market efficiency are really joint tests of an asset pricing model and market efficiency.“Anomalies” such as calendar effects or mean reversion may be due to bad asset pricing models.

  22. New evidence may not be fatal: • Data Mining: If you let computers churn long enough, you will find an anomaly. Journals publish anomalies, not confirmations of market efficiency.

  23. The new evidence may not be fatal: Market Crashes: Can be explained with a rational investor model... • Small changes in interest rates and risk perceptions can induce large changes in share prices. • Cumulative impact of a series of small events can induce changes in risk perceptions (“straw that broke the camel’s back”)

  24. The new evidence may not be fatal: Superior Analysts: • Warren Buffett takes an active role on boards of the companies he invests in. His spectacular success may have more to do with his directorial ability than his aptitude for picking stocks. • Peter Lynch: You cannot rule out the possibility that Lynch was just lucky. His true brilliance lies in recognizing that his luck would not hold out. Thus, he retired early.

  25. The new evidence may not be fatal: • Superior Analysts: • Man tends to see causality in random patterns in the data, thereby attributing abnormal returns to skill rather than to luck.

  26. The new evidence may not be fatal: Superior Analysts: • Example: Assume you are holding a stock worth $50. Now, further assume its value in each successive period is determined by the flip of a fair coin. Whenever coin shows “heads,” stock gains $1. Whenever coin shows “tails,” the stock loses $1. Let’s flip a coin repeatedly and track stock price.

  27. How do you explain the brokers puzzle? • “There’s a sucker born every minute” P.T. Barnum • Brokers add value by selling financial planning, not by picking stocks

  28. What’s the point of all this? • To overthrow efficient markets paradigm, you need: • damning evidence. • a better model. Behavioralists have neither!

  29. Lessonsfrom the Real World “I have personally tried to invest money, my client’s money and my own, in every single anomaly and predictive advice that academics have dreamed up…I have attempted to exploit the so-called year-end anomalies and a whole variety of strategies supposedly documented by academic research. And I have yet to make a nickel on any of these supposed market inefficiencies.” Richard Roll Professor of Finance UCLA

  30. Bottom Line:The stock market is efficient. There is no way to get rich quick.

  31. Efficient Market Lessons for Investing • Take more risk • commit fraud Only two ways to post consistently high returns:

  32. Remember: Brother Ty’s Seventh Law of Spiritual and Financial Growth • “The only way to get rich from a get-rich book is to write one.” Source: Christopher Buckley and John Tierney God is My Broker

  33. Efficient Market Lessons for Investing Invest in an stock index fund and hold: • don’t pick stocks • don’t try to time market

  34. October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February Mark Twain Pudd’nhead Wilson

  35. Efficient Market Lessons for Investing • How much of your wealth should you hold in stocks? • A lot… even more if you are young

  36. How to use a broker: • Use him as a financial planner. • Let him educate you about risk- return trade-offs. • Don’t let him pick stocks for you.

  37. Beware: A Fool and His Money are Soon Parted...

  38. Beware: A Fool and His Money are Soon Parted...

  39. Beware: A Fool and His Money are Soon Parted...

  40. Questions ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?

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