The Efficient Market Hypothesis (EMH)

• Efficient Market Hypothesis: stock prices already reflect all available information.

• A forecast about favorable future performance leads to favorable current performance, as

market participants rush to trade on new information.

• Any information that could be used to predict stock performance should already be
reflected in stock prices.

• Prices change until expected returns are exactly commensurate with risk.

• New information is unpredictable; if it could be predicted, then the prediction would be

part of today’s information.

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Stock Price Behavior

• Stock prices that change in response to new (unpredictable) information also must move
unpredictably, and thus randomly.
• Prices as likely to go up as to go down.
• Prices independent of past performance.

• Stock price changes follow a random walk. This does not imply irrationality in the level of
prices!
• Prices evolve randomly.
• Predictability would imply a «gold mine» for investors (cannot persist).

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Example

• Suppose that a model predicts with great confidence that XYZ stock price, currently at
$100 per share, will rise dramatically in 3 days to $110. What would all investors with
access to the model’s prediction do today?

• Obviously, they would place a great wave of immediate buy orders to cash in on the
prospective increase in stock price.

• However, no one holding XYZ would be willing to sell.

• The net effect would be an immediate jump in the stock price to $110.

• The forecast of a future price increase will lead instead to an immediate price increase,
i.e., the stock price will immediately reflect the “good news” implicit in the model’s
forecast.

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Stock Price Response to New Information

• Cumulative abnormal returns of

target companies before takeover
attempts.

• Stock price jump on the day of the

announcement.

• No further drift after the

announcement day.

• Pre-announcement drift: indication

for insider trading.

Source: Bodie Z., Kane A., Marcus A. (2020): Investments

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The Role of Competition

• Competition is the source of market efficiency: Strong competition assures that prices
reflect information.

• Information-gathering is motivated by desire for higher investment returns.

• With many well-backed analysts willing to spend considerable resources on research,

easy pickings in the market are rare.

• The marginal return on research activity may be so small that only managers of the
largest portfolios will find them worth pursuing.

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Forms of Market Efficiency

• Weak Form
• All information on trading data (prices, open interest, etc.) is already reflected in the
price.
• No point in doing trend or technical analysis.

• Semi-strong Form
• In addition to all trading data information, all publicly available information on firms’
fundamentals is already reflected in the price.
• No point in doing fundamental analysis.

• Strong Form
• Prices reflect all the information relevant to the firm, including information only
available to insiders.
• No gains from trading on insider information.

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Stock Analysis

• Technical Analysis: using prices and volume information to predict future prices.
• Success depends on a sluggish response of stock prices to fundamental supply-and-
demand factors.
• Only profitable if weak-from efficiency is violated.
• However, price patterns resp. profitable trading strategies are self-destructive.
• Examples: relative strength, resistance levels

• Fundamental Analysis: using economic and accounting information to predict future

prices.
• Attempt to determine firms’ present value.
• Only profitable if semi-strong-from efficiency is violated.
• Try to find firms that are better than everyone else’s estimate, or poorly run firms that
are not as bad as the market thinks.
• Success only if the analysis is better than the analysis of most other investors.

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Grossman-Stiglitz Paradox

• If markets were strong-form efficient, nobody would benefit from research.

• Investors will have an incentive to spend time and resources to analyze and uncover
new information only if such activity is likely to generate higher returns.
• Consequence: No research is conducted.

• But: how can markets be strong-form efficient and reflect all information if no research is
conducted?
Markets cannot be strong-form efficient since information gathering has to be
rewarded.
Since information is costly, investors will receive a compensation for information
gathering through higher returns.

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Portfolio Management

• Active Management:
• An expensive strategy that tries to beat the market.
• Requires extensive analysis and uncommon approaches to beat the market.
• Suitable only for large portfolios since gains are likely to be small in percentage
terms.
• Small investors can gain from economies of scale by mutual fund investment.

• Passive Management:
• No attempt to outsmart the market.
• Investment in Index Funds and ETFs (well-diversified portfolio).
• Substantially lower costs.

• Even if the market is efficient a role exists for portfolio management:

• Diversification
• Tax considerations: different taxation of interest, dividends, and capital gains.

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Insider Information

• Insiders’ trades are strongly regulated and limited.

• Markets are unlikely to reflect all inside information and should thus not be strong-
form efficient.
• Insiders usually must report large trades within a few business days.

• Ability of insiders to trade profitably in their own stock has been empirically documented.

• Following insiders’ transactions after they have been made public does not yield superior
risk-adjusted returns.
Indication that markets are semi-strong efficient, i.e., that they quickly process public
information.

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Resource Allocation

• If markets were inefficient, resources would be systematically misallocated.

• Distorted prices give misleading signals (and incentives) as to where the economy may
best allocate resources.
• Firm with overvalued securities can raise capital too cheaply.
• Firm with undervalued securities may have to pass up profitable opportunities
because cost of capital is too high.

• Frictions (e.g., due to regulation, transaction costs, etc.) lead to inefficiencies and can
negatively impact the functioning of markets.

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Patterns in Stock Returns

• Short-term: momentum effect in the aggregate stock market and in the cross-section of
stock returns.

• Long-term: reversal effect in the aggregate stock market and in the cross-section of stock
returns.

• The existence of patterns in stock returns violates the weak form of the EMH.

• Potential Explanations:
• Overreaction in the short-term, correction in the long-term.
• Variation in the market risk premium over time.

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Anomalies (1/2)

• Several simple measures (e.g., price–earnings ratio, market capitalization, book-to-

market ratio) seem to predict abnormal risk-adjusted returns (i.e., alphas) of stocks.
• Difficult to reconcile with the semi-strong form of the efficient market hypothesis.
• Therefore often referred to as market anomalies.

• Problem: need to adjust for risk before evaluating the success of an investment strategy.
• Risk-adjusted returns are joint tests of the efficient market hypothesis and the risk
adjustment procedure (e.g., based on the CAPM) .
• Either the EMH or the risk adjustment is wrong.
• Assumptions of risk adjustment methods in general more questionable.

• Implausible that investment strategies based on simple measures are enough to generate
abnormal returns.
• More likely that returns are not properly adjusted for risk.
• Measures are likely to be useful additional descriptors of risk.

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Anomalies (2/2)

• Return anomalies such as the price-earnings, small-firm, and book-to-market effects are
among the most puzzling phenomena in empirical finance.

• Potential Explanations:

1. Variables might act as proxies for systematic risks, and the associated excess
returns reflect the risk premia associated with these risks.
Consistent with the EMH: higher expected returns for higher systematic risk.

2. Systematic errors in forecasts (errors in information processing or behavioral biases)

leading to underpricing of the respective stocks and subsequently higher expected
returns.
Inconsistent with the EMH because risk-adjusted returns are predictable.

3. Data Mining: documented anomalies and patterns might be due to pure chance and
might just be statistical artifacts.
Would not contradict EMH.

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Post-Publication Performance

• McLean and Pontiff (2016) compare

in-sample, out-of-sample, and post-
publication returns of 97 anomalies.
• In-sample: original study samples
• Out-of-sample: until 2013

• If an anomaly disappears out-of-

sample, then it is most likely due to
data snooping.

• If an anomaly disappears after its

publication, then it is most likely due to
mispricing.

• Results indicate that

• investors learn about mispricing
from academic publications.
• a considerable fraction of
anomaly returns is due to data
mining.
Source: McLean and Pontiff (2016)

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Bubbles

• Bubbles:
• Rapid run-up in prices creates widespread expectation that they will continue to rise.
• More and more investors try to get in on the action and push prices even further.
• When the run-up stalls, the bubble bursts and ends in a crash.

• How bubbles arise:

• During periods of stability and rising prices, investors extrapolate that stability into
the future and become more willing to take on risk.
• Risk premiums shrink, leading to further increases in asset prices, and expectations
become even more optimistic in a self-fulfilling cycle.
• In the end, pricing and risk taking become excessive and the bubble bursts.
The initial period of stability fosters behavior that ultimately results in instability.

• Bubbles are difficult to predict and exploit:

• Become obvious only in retrospect.
• The run-up in prices is contemporaneously often rationalized by new, profitable
prospects.

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Market Efficiency in Reality

• An overly doctrinaire belief in efficient markets can paralyze the investor and make it
appear that no research effort can be justified.

• However, there are probably enough anomalies to justify the search for underpriced
securities

• The market is competitive enough that only differentially superior information or insight
will earn money.

• The margin of superiority that any professional manager can add is so slight that the
statistician will not easily be able to detect it.

• Conclusion:
Markets are generally very efficient, but (small) rewards to especially diligent,
intelligent, or creative investors may still exist.
However, they are unlikely and/or small for the average investor.

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Behavioral Finance

• Conventional Finance:
• Assumes the EMH to hold.
• Investors are rational, respectively the irrationality of some investors is counteracted
by rational investors.
• Prices reflect all available information.
• Resources are allocated efficiently.

• Behavioral Finance:
• Investors’ irrationality can lead to wrong security prices.
• Exploitation of wrong security prices may be difficult for sophisticated investors,
wherefore mispricing can be persistent.

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Types of Irrationality

• Errors in Information Processing: Investors do not always process information correctly

and/or timely.
• Misestimation of events’ true probabilities.
• Incorrect beliefs about probability distribution of future returns.

• Behavioral biases: Even when given a probability distribution of returns, investors may
make inconsistent or suboptimal decisions.
• Biases result in less than rational decisions, even with perfect information.

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Errors in Information Processing

• Forecasting Errors: Too much weight is placed on recent experiences.

• Forecasts are too extreme given the uncertainty inherent in their information.
• Example: P/E-effect might be down to earnings expectations that are too extreme.

• Overconfidence: Investors overestimate their abilities and the precision of their

information.

• Conservatism: Investors are slow to update their beliefs and underreact to new
information.
• Prices will fully reflect new information only gradually.
• Could be the reason for the momentum effect.

• Sample Size Neglect and Representativeness: Investors are too quick to infer a pattern or
trend from a small sample.

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Behavioral Biases (1/3)

• Framing: Investors’ decisions are affected by how choices are framed.

• Example: an investor may reject an investment opportunity when it is posed in terms
of the possibility of losses but may accept that same opportunity when described in
terms of the possibility of gains.

• Mental Accounting: Investors may segregate accounts or monies and take risks with their
gains that they would not take with their principal.
• Special case of framing.
• Investors build their portfolios in distinct “mental account layers”, where each layer
may be tied to particular goals and elicit different levels of risk aversion.
• Example: an investor may take a lot of risk with one investment account but establish
a very conservative position with another account that is dedicated to his child’s
education.

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Behavioral Biases (2/3)

• Regret Avoidance: Investors blame themselves more when an unconventional or risky

decision turns out badly.
• Losses on conventional investments can be more easily attributed to bad luck rather
than bad decision making and cause less regret.
• Example: buying a blue-chip portfolio that turns down is not as painful as
experiencing the same losses on an unknown start-up firm.
• Consistent with size and book-to-market effects.

• Ambiguity aversion: Investors prefer risk over uncertainty.

• Uncertainty: probability distribution of outcomes is not known.
• Risk: probability distribution of outcomes is known (quantified uncertainty).
• Can explain the equity premium puzzle.

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Behavioral Biases (3/3)

• Expected Utility Theory: Utility depends on

level of wealth, and marginal utility declines
with increasing wealth (causing risk aversion).

• Prospect Theory:
• Utility depends on changes in current
wealth.
• Utility is concave with respect to gains and
convex with respect to losses.
Investors are risk-seeking with respect to
losses.
Loss Aversion: People tend to be more
sensitive to decreases in their wealth than
to increases.

Source: Bodie Z., Kane A., Marcus A. (2020): Investments

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Limits to Arbitrage (1/2)

• Behavioral biases would not matter if rational arbitrageurs could fully exploit the mistakes
of irrational investors.

• In practice, the actions of such arbitrageurs are limited and prevent them from exploiting
mispricings.
• Cannot force prices to match intrinsic value.

• Fundamental Risk: exploiting mispricings is not risk-free.

• Intrinsic value and market value may take too long to converge.
• Mispricing can even get worse.
• Short investment horizons of investors.
• “Markets can remain irrational longer than you can remain solvent.”

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Limits to Arbitrage (2/2)

• Implementation Costs: Transactions costs and restrictions on short selling can limit
arbitrage activity.

• Model Risk: an apparent profit opportunity is more apparent than real.

• The price implied by the rational investor’s model might be wrong and the current
market price is actually correct.
• If everyone else is using a wrong model, the price will not converge to its true value.

• Implications:
• Absence of profit opportunities does not necessarily imply that markets are efficient.
• Failure of money managers to systematically outperform passive investment
strategies need not imply that markets are efficient.

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Conclusions

• Investors who are aware of the potential pitfalls in information processing and decision
making that seem to characterize their peers should be better able to avoid such errors.

• The extent to which limited rationality affects asset pricing remains controversial.

• The behavioral explanations of efficient market anomalies do not give guidance on how to
exploit irrationalities.

• The behavioral approach is still somewhat unstructured: virtually any anomaly can be
explained by some combination of irrationalities chosen from the extensive list of
information processing errors and behavioral biases.

• Anomalies that are consistent with one type of irrationality are often inconsistent with
other types of irrationality.

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Agenda

The Efficient Market Hypothesis

Empirical Evidence on Market Efficiency
Behavioral Finance
Investor Behavior

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Underdiversified Portfolios: Low Number of Stocks

• Individual investor data (~60,000 clients)

from a large U.S. discount brokerage
house for the period from 1991 to 1996.

• Average investor holds a four-stock

portfolio.

• More than 25% of investor portfolios

contain only one stock, and more than
50% contain only one to three stocks.

Actual investor portfolios highly Source: Goetzmann and Kumar (2008)

concentrated and underdiversified.
Level of portfolio diversification varies across investors.

Under-diversification is greater among younger, low-income, less-educated, and less

sophisticated investors.

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Underdiversified Portfolios: Correlated Stocks

• Comparison of the variances of actual

investor portfolios with the variances
of randomly constructed matching
portfolios.

• The mean normalized variance of

investor portfolios is ~25% higher
than the mean normalized variance of
randomly chosen portfolios.

• Difference increases with the average

size of investor portfolios.

Actual investor portfolios exhibit a

worse risk-return trade-off than Source: Goetzmann and Kumar (2008)
randomly chosen portfolios.

Systematic under-diversification.

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Underdiversified Portfolios: Home Bias

• Investors primarily invest in stocks from their home country.

High exposure to economic shocks in their home country.

Source: Wilshire Consulting (2008), Greenwich Associates (2007)

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Underdiversified Portfolios: Explanations

• Behavioral Explanations:
• Overconfidence: overestimation of stock picking ability, of precision of information
about familiar stocks, or of expected returns of familiar stocks.
• Ambiguity Aversion: focus on stocks that are perceived to be less ambiguous.

• Non-Behavioral Explanations:
• Transaction costs
• Diversification of risks of non-traded assets (e.g., human capital, private businesses).
• Tax Optimization

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Excessive Trading

• Individual household data

(~66,000 clients) from a large
U.S. broker for the period from
1991 to 1996.

• Gross returns not related to

trading activity.

• Those who trade more have

lower net returns due to high
trading costs.

• Men lose more than women.

Excessive trading hurts return

on investments

Source: Barber and Odean (2000)

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Excessive Trading: Explanations

• Behavioral Explanations:
• Overconfidence: overestimation of precision of information as well as overestimation
of ability relative to other investors imply sub-optimally high trading of investors.
• Sensation-seeking / entertainment: people like to gamble.

• Non-Behavioral Explanations:
• Liquidity shocks
• Rebalancing
• Tax Optimization

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Disposition Effect

• The default hazard rate is the

return category that includes
returns of -2% to 2%.

• The tendency to sell a stock

increases dramatically as returns
increase.

• Negative returns since a stock

was purchased also increase the
hazard rate of selling, but not as
dramatically as positive returns.

Investors are more likely to sell

stocks with gains than those with Source: Barber and Odean (2013), Handbook of the Economics of Finance,
Chapter 22
losses.

Investors are reluctant to realize losses and therefore hold on to losing investments.

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Disposition Effect: Explanations

• Behavioral Explanations:
• Loss aversion and mental accounting: investors try to “avoid” making losses by not
realizing them and separating losing and winning positions in different “accounts”.
• Regret Avoidance: investors avoid to acknowledge that they have made a bad
investment decision that resulted in losses.
• Realization utility: people derive extra utility from realizing their gains as compared to
having only “paper” gains.

• Non-Behavioral Explanations:
• Rebalancing
• Tax Optimization

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