Market Efficiency and Behavioral Finance -Abnormally large profits cannot be consistently earned using

public information
Market Price Behavior Learning Goals -Any price anomalies are quickly found out and the stock
Describe the characteristics of an efficient market, explain market adjusts
what market anomalies are, and note some of the challenges Strong Form EMH
that investors face when markets are efficient. -There is no information, public or private, that allows
Summarize the evidence which indicates that the stock investors to consistently earn abnormally high returns
market is efficient.
List four “decision traps” that may lead investors to make 10 Figure 9.3 Daily Stock Price Reactions Surrounding Positive
systematic errors in their investment decisions. Earnings News
Source: Andreas Neuhierl, Anna Scherbina, and Bernd
3 Market Price Behavior Learning Goals (cont’d) Schlusche. “Market Reaction to Corporate Press Releases,”
Explain how behavioral finance links market anomalies to forthcoming in the Journal of Financial and Quantitative
investors’ cognitive biases. Analysis.
Describe some of the approaches to technical analysis.
Compute and use technical trading rules for individual stocks 11 Market Anomalies
and the market as a whole.  Calendar Effects Small-Firm Effect
- Stocks returns may be closely tied to the time of year or
Random Walks and Efficient Markets time of week
Random Walk: the theory that stock price movements are - Questionable if really provide opportunity
unpredictable, so there is no way to know where prices are - Examples: January effect, weekend effect
headed
- Studies of stock price movements indicate that they do not  Small-Firm Effect
move in neat patterns -Size of a firm impacts stock returns
- This random pattern is a natural outcome of markets that -Small firms may offer higher returns than larger firms, even
are highly efficient and respond quickly to changes in after adjusting for risk
material information -(market impact of trading?)
- Definition of random walk: The best prediction of the future
price is today’s price.  Post Earnings Announcement Drift (Momentum)
-Stock price adjustments may continue after earnings
Efficient Market: a market in which securities reflect all adjustments have been announced
possible information quickly and accurately -Unusually good quarterly earnings reports may signal buying
 To have an efficient market, you must have: opportunity
- Many knowledgeable investors actively analyzing and
trading stocks  Value Effect
- Information is widely available to all investors - Uses P/E ratio to value stocks
- Events, such as labor strikes or accidents, tend to happen - Low P/E stocks may outperform high P/E stocks, even after
randomly adjusting for risk
- Investors react quickly and accurately to new information
13 Figure 9.4 Post Earnings Announcement Drift
6 Figure 9.1 Walmart Quarterly Revenues
7 Figure 9.2 Walmart’s Stock Price
8 Efficient Market Hypothesis

Efficient Market Hypothesis (EMH): information is reflected

in prices—not only the type and source of information, but
also the quality and speed with which it is reflected in prices.
The more information that is incorporated into prices, the
more efficient the market becomes.

Levels of the EMH

-Weak Form EMH
-Semi-strong Form EMH
-Strong Form EMH
14 Possible Explanations
9 Levels of EMH  Stocks that appear to earn abnormally returns are
Weak Form EMH actually riskier, so higher returns merely represent
-Past data on stock prices are of no use in predicting future compensation for risk
stock price changes  Some anomalies may simply be patterns in that data
-Everything is random that appeared by chance and are thus not likely to
-Should simply use a “buy-and-hold” strategy persist over time
Semi-strong Form EMH
 Behavioral biases may cause investors to make 21 Using Behavioral Finance to Improve Investment Results
systematic mistakes when they invest, and those (Table 9.1)
mistakes create inefficiencies in the market  Don’t hesitate to sell a losing stock
 Don’t chase performance
15 Investor Behavior and Security Prices  Be humble and open-minded
 Overconfidence  Review the performance of your investment on a
- Investors tend to be overconfident in their judgment, periodic basis
leading them to underestimate risks  Don’t trade too much
 Self-Attribution Bias
- Investors tend to take credit for successes and blame others 22 Technical Analysis
for failures  Before financial data/financial statements were
- Investors will follow information that supports their beliefs required to be disclosed, investors could only watch the
and disregard conflicting information stock market itself to determine buy-or-sell decisions
 These biases may cause investors to trade too often  Investors began keeping “charts” of stock market
movements to look for patterns, or “formations” that
 Loss Aversion indicated whether to buy or sell
-Investors dislike losses much more than gains  Studies have shown that anywhere from 20% to 50% of
-Investors will hang on to losing stocks hoping they will the price behavior of a stock can be traced to overall
bounce back market forces

Representativeness 23 Technical Analysis (cont’d)

-Investors tend to draw strong conclusions from small Technical Analysis is the study of the various forces at work
samples in the marketplace and their affect on stock prices.
-Investors tend to underestimate the effects of random
chance - Focus is on trends in a business’ stock price and the overall
stock market
17 Investor Behavior and Security Prices (cont’d) - Stock prices are a function of supply and demand for shares
 Narrow Framing of stock
- Investors tend to analyze a situation in isolation, while - Used to get a general sense of where the stock market is
ignoring the larger context going in the next few months
- Several technical indicators may be used together
Belief Perseverance
- Investors tend to ignore information that conflicts with their 24 Market Technical Indicators
existing beliefs Confidence Index
- Looks at ratio between yields on high-grade corporate
Familiarity Bias bonds compared to intermediate-grade corporate bonds
- Investors buy stocks that are familiar to them without - Optimism and pessimism about the future outlook is
regard to whether the stocks are good buys or not reflected in the bond yield spread
- Trend of “smart money” is revealed in bond market before
18 Behavioral Finance at Work in the Markets it shows up in stock market
Stock Return Predictability
- It maybe profitable to buy underperforming stocks when 25 Market Technical Indicators (cont’d)
they are out-of-favor Market Volume
- Momentum of stock prices up and down tends to continue - Pure supply and demand analysis for common stocks
over 6- to 12-month time horizons -Strong market when volume goes up
- Value stocks may outperform growth stocks -Weak market when volume goes down

19 Behavioral Finance at Work in the Markets (cont’d) 26 Market Technical Indicators (cont’d)
Investor Behavior Breadth of the Market
-Investors who believe they have superior information tend - Looks at number of stock prices that go up (advances)
to trade more, but earn lower returns versus number of stock prices that go down (declines)
- Investors tend to sell stocks that have risen in value rather - Strong market when advances outnumber declines
than declined - Weak market when declines outnumber advances
- Investors acting on emotions instead of facts may reduce
market efficiency 27 Market Technical Indicators (cont’d)
Short Interest
20 Behavioral Finance at Work in the Markets (cont’d) - Looks at number of stocks that have been sold short at any
Analyst Behavior given time
- Analysts may be biased by “herding” behavior, where they - Can give two different interpretations:
tend to issue similar recommendations for stocks  Measure of Future Demand for Stock
- Analysts may be overly optimistic about a favorite stock’s - Strong market when short sales are high since guarantees
future future stock sales to cover the short positions
 On Balance Volume
 Measure of Present Market Optimism or Pessimism - Tracks the volume to price change relationship as a running
- Weak market when short sales are high since professional total
short sellers think stocks will decline - Up-volume occurs when stock closes higher and is added to
running total; down-volume occurs when stock closes lower
28 Market Technical Indicators (cont’d) and is subtracted from running total
Contrary Opinion and Odd-Lot Trading - Direction of indicator is more important than actual value
- Measures the volume of small traders - Used to confirm price trends
- Assumes that small traders will do just the opposite of what - Bull market when OBV values are higher
should be done - Bear market when OBV values are lower
 Panic and sell when market is low
 Speculate and buy when market is high 35 Using Technical Analysis
- Bull market when odd-lot sales significantly outnumber Charting
odd-lot purchases - Shows visual summary of stock activity over time
- Bear market when odd-lot purchases significantly - Easy to use and to understand
outnumber odd-lot sales - Use to spot developing trends

29 Figure 9.5 Basic Market Statistics 36 Using Technical Analysis

(Source: accessed August 12, 2012.) Chart Formations
- Looking for patterns, or formations, that historically meant
30 Trading Rules and Measures that stocks were going up or down
Advance-Decline Line - Buy when stocks break through a “line of resistance”
- Measures the difference between stocks closing higher and - Sell when stocks break through a “line of support”
stocks closing lower than previous day
- Difference is plotted on graph to view trends 37 Figure 9.6 Some Popular Chart Formations
- Used as signal to buy or sell stocks 38 Using Technical Analysis (cont’d)
- Bull market when advances outnumber declines Moving Averages
- Bear market when declines outnumber advances - Tracks data (usually stock price) as average value over time
- Used to “smooth out” daily fluctuations and focus on
31 Trading Rules and Measures (cont’d) underlying trends
New Highs–New Lows - Usually calculated over periods ranging from 10 to 200 days
- Measures the difference between stocks reaching a 52-
week high and stocks reaching a 52-week low 39 Figure 9.7 A 100-Day Moving Average Line
10-day moving average is plotted on graph to view trends 40 Table 9.1 Using Behavioral Finance to Improve Investment
- Used as signal to buy or sell stocks Results
- Bull market when highs outnumber lows
- Bear market when lows outnumber highs

32 Trading Rules and Measures (cont’d)

The Arms Index or Trading Index (TRIN)
- Combines advance-decline line with trading volume
- Used as signal to buy or sell stocks

--Bull market when TRIN values are lower

- Bear market when TRIN values are higher

33 Trading Rules and Measures (cont’d)

Mutual Fund Cash Ratio (MFCR)

- Tracks cash position of mutual funds
- High cash positions in mutual funds provides liquidity for
future stocks purchases or protection from future mutual
fund withdrawals

- MFCR = Mutual funds cash position divided total asset

under manager

- Bull market when MFCR values are higher

- Bear market when MFCR values are lower

34 Trading Rules and Measures (cont’d)