Efficient Market Hypothesis vs. Behavioral Finance

1. Efficient Market Hypothesis vs. Behavioral Finance • Market Efficiency • Random walk versus market efficiency • Versions of market efficiency • Technical analysis vs. fundamental analysis • Predictors of future returns and market anomalies • Behavioral finance Market Efficiency and Behavioral Finance

2. Cumulative Abnormal Returns Around Takeover Attempts: Target Companies Market Efficiency and Behavioral Finance

3. Stock Price Reaction to CNBC Reports Market Efficiency and Behavioral Finance

4. EMH and Competition • Stock prices fully and accurately reflect publicly available information. • Once information becomes available, market participants analyze it. • Competition assures prices reflect information. • What does competition mean here? -- page 351 • Is there a role for active portfolio management in an efficient market? Market Efficiency and Behavioral Finance

5. Forms of the EMH • Weak • Semi-strong • Strong • See page 347-348. Market Efficiency and Behavioral Finance

6. Types of Stock Analysis • Technical Analysis - using prices and volume information to predict future prices. • Weak form efficiency & technical analysis • Chartist • Relative strength versus resistance levels • Fundamental Analysis - using economic and accounting information to predict stock prices. • Semi strong form efficiency & fundamental analysis Market Efficiency and Behavioral Finance

7. Technical Analysis • Relative strength – page 348 • Resistance levels – upper bound or • Support levels – lower bound • Whether a workable technical trading rule will continue to work in the future once it becomes publicly known? Market Efficiency and Behavioral Finance

8. Fundamental Analysis • Uses earnings and dividend prospects of the firm, expectations of future interest rates, and risk evaluation of the firm to determine proper stock prices. • Fundamental analysis is much beyond identifying well-run firms with good prospects. It is to identify companies better than every else’s estimate. Market Efficiency and Behavioral Finance

9. Active or Passive Management • Active Management • Security analysis • Timing • Passive Management • Buy and Hold • Index Funds Market Efficiency and Behavioral Finance

10. Market Efficiency & Portfolio Management Even if the market is efficient a role exists for portfolio management: • Appropriate risk level • Tax considerations • Other considerations Market Efficiency and Behavioral Finance

11. Empirical Tests of Market Efficiency • Event studies • Assessing performance of professional managers • Testing some trading rule Market Efficiency and Behavioral Finance

12. Issues in Examining the Results • Magnitude Issue • Selection Bias Issue: investing in small stocks • Lucky Event Issue Market Efficiency and Behavioral Finance

13. Weak-Form Tests • Serial Correlation • Momentum • Returns over Long Horizons Market Efficiency and Behavioral Finance

14. Experience with 911 • Anticipating market chaos, panic selling and a disastrous loss of value in the wake of the attacks, the NYSE and the Nasdaq remained closed until September 17, the longest shutdown since 1933. Moreover, many trading, brokerage and other financial firms had offices in the World Trade Center and were unable to function in the wake of the tragic loss of life and collapse of both towers. • On the first day of NYSE trading after 9/11, the market fell 684 points, a 7.1% decline, setting a record for the biggest loss in exchange history for one trading day. At the close of trading that Friday, ending a week that saw the biggest losses in NYSE history, the Dow Jones was down almost 1,370 points, representing a loss of over 14%. • Major stock sell-offs hit the airline and insurance sectors as anticipated when trading resumed. Hardest hit were American Airlines and United Airlines, carriers whose planes were hijacked for the terrorist attacks. • American Airlines (NYSE:AMR) stock dropped from a $29.70 per share close of September 11 to $18.00 per share close on September 17, a 39% decline. United Airlines (NYSE:UAL) stock dropped from $30.82 per share close to $17.50 per share on the close on September 17, a 42% decline. Market Efficiency and Behavioral Finance

15. Also: Program trading; algorithmic trading; and high-frequency trading: According to the New York Stock Exchange, in 2006 program trading accounts for about 30% and as high as 46.4% of the trading volume on that exchange every day. http://www.programtrading.com/ The greatest point loss of the Dow Jones Industrial Average was 777.68 points on September 29, 2008. Market Efficiency and Behavioral Finance

16. Predictors of Broad Market Returns • Fama and French • Aggregate returns are higher with higher dividend ratios • Campbell and Shiller • Earnings yield can predict market returns • Keim and Stambaugh • Bond spreads can predict market returns Market Efficiency and Behavioral Finance

17. Anomalies • P/E Effect • Small Firm Effect (January Effect) • Neglected Firm • Book-to-Market Effects • Post-Earnings Announcement Drift http://biz.yahoo.com/research/earncal/today.html Market Efficiency and Behavioral Finance

18. Returns in Excess of Risk-Free Rate and in excess of the Security Market Line for 10 Size-Based Portfolios, 1926 – 2005 Market Efficiency and Behavioral Finance

19. Average Monthly Returns as a Function of the Book-To Market Ratio, 1963 – 2004 Market Efficiency and Behavioral Finance

20. Cumulative Abnormal Returns in Response to Earnings Announcements Market Efficiency and Behavioral Finance

21. Mutual Fund Performance • Some evidence of persistent positive and negative performance. • Potential measurement error for benchmark returns. • Style changes • May be risk premiums Market Efficiency and Behavioral Finance

22. Persistence of Mutual Fund Performance Market Efficiency and Behavioral Finance

23. Behavioral Finance • The premise of behavioral finance is that conventional financial theory ignores how real people make decisions and that people make a difference. • Investors Do Not Always Process Information Correctly • Investors Often Make Inconsistent or Systematically Suboptimal Decisions Market Efficiency and Behavioral Finance

24. Behavioral Biases • Framing • Decisions seem to be affected by how choices are framed – page 387 • example • Mental Accounting • A special form of framing in which people segregate certain decisions • example • Regret Avoidance • Individuals would have more regrets when their decisions are more unconventional • example • Prospect Theory • Traders become risk seeking after they lose money Market Efficiency and Behavioral Finance

25. Prospect Theory Graphs Market Efficiency and Behavioral Finance

26. Prospect theory (2) • Loss aversion: utility depends not on the level of wealth from current levels. • The convex curvature to the left of the origin will induce investors to be risk seeking rather risk averse when it comes to losses • Traders in T-bond futures often take significantly greater risk in afternoon sessions following morning sessions in which they have lost money Market Efficiency and Behavioral Finance

27. Limits to Arbitrage • Fundamental Risk • Implementation Costs • Model Risk Market Efficiency and Behavioral Finance

28. Limits to Arbitrage and the Law of One Price • Violations • Siamese Twin Companies • Equity Carve-outs • Closed-End Funds Market Efficiency and Behavioral Finance

29. Bubbles and Market Efficiency • The bust of dot-com bubble • Financial crisis – housing price bubble • Hard to be justified by the position that security prices represent rational, unbiased assessments of intrinsic value. • Dynamic risk taking – excessive risk taking in bubble period Market Efficiency and Behavioral Finance

30. Technical Analysis and Behavioral Finance • Trends and corrections • momentum (page 393) • Dow theory: primary trend, secondary trend, and tertiary trend • see Figure 12-4 • Moving averages • Breadth: the spread between the number of stocks that advance and decline in price. Market Efficiency and Behavioral Finance

31. Technical Analysis and Behavioral Finance • Trin statistic • Confidence index • Put/call ratio Market Efficiency and Behavioral Finance

32. Investment-based CAPM • Cochrane (1991, 1996) • Low costs of capital imply high NPV of new projects and high investment • High costs of capital imply low NPV of new project and low investment • Inverse relationship between expected return and investments Market Efficiency and Behavioral Finance