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Efficient Markets

Efficient Markets. Riccardo Colacito. Common wisdom. Two economists are walking down the street. They spot a $20 bill on the sidewalk. One starts to pick it up, but the other one says, “Don’t bother: if the bill were real someone would have picked it up already.”. What does it mean?.

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Efficient Markets

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  1. Efficient Markets Riccardo Colacito

  2. Common wisdom Two economists are walking down the street. They spot a $20 bill on the sidewalk. One starts to pick it up, but the other one says, “Don’t bother: if the bill were real someone would have picked it up already.”

  3. What does it mean? If markets are efficient, then prices reflect all available information. That is no security is underpriced, i.e. there’s no easy money. Is it true?

  4. Analysis of the efficient market hypothesis Proceed in three steps: • Formalize the concept of efficient markets • Look at the data • Explore competing explanations

  5. The random walk hypothesis Price changes should be random and unpredictable Randomness in price changes does not mean irrationality in the level of prices

  6. Forms of Efficient Markets Hypothesis (EMH)

  7. 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

  8. Question • According to the strong EMH: what’s your best guess for the price of a security tomorrow? • Today’s price plus something that is random and unpredictable! • If there is no hope to outsmart the market, why bother? • Efficient diversification • Pick preferred level of risk

  9. A role for stock analysis • Technical Analysis - using prices and volume information to predict future prices • Weak form efficiency & technical analysis • Fundamental Analysis - using economic and accounting information to predict stock prices • Semi strong form efficiency & fundamental analysis

  10. Insider trading The Securities and Exchange Commission requires all insiders to register all their trading activity. SEC publishes these trades in an Official Summary of Security Transactions and Holdings since 2002. 10

  11. Are markets really efficient? • Patterns in stock returns • Anomalies • Competing explanations

  12. Patterns in stock returns • Serial correlation of stock market returns • Momentum • Reversal • Short horizons: positive correlation • Intermediate horizons: momentum effect • Long horizons: negative serial correlation in the performance of aggregate market

  13. Anomalies The small firm in January effect The neglected firm effect Book to market ratios Postearnings announcement price drift

  14. January effect

  15. Neglected firm effect The tendency of investments in stock of less well known firms to generate abnormal returns

  16. Neglected firm effect

  17. Neglected firm effect: is it really a puzzle? Information about such firms is less available Not a market inefficiency but a risk premium 17

  18. Book-to-market ratios

  19. Postearning announcement price drift Sluggish response of stock prices to firms’ earnings announcements

  20. Trading costs? Investors may refrain from buying securities due to high trading costs Hence prices fail to take into account the announcement fully and quickly

  21. A competeing explanation: the behavioral critique Investors do not always process information correctly (come up with wrong forecasts) Investor make inconsistent or systematically suboptimal decision

  22. Mistakes in processing information Forecasting errors Sample size neglect Overconfidence

  23. Behavioral biases Framing: decisions are affected by how choices are framed Mental accounting: people segregate certain decisions Regret avoidance: people regret mistakes more when following unconventional decisions

  24. Behavioral critique: should we buy it? Behavioral approach is too unstructured Any anomaly can be explained by some combination of irrationalities Lack of statistical significance of many tests Not yet mainstream

  25. The punch line The market is competitive enough Only differentially superior information will earn money Easy pickings have been picked Enough anomalies in the empirical evidence to justify the search for underpriced securities

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