Efficient Market Hypothesis

A hypothetical scenario
What if you have figured out the following:
Buy if out of the 20 trading days for the past month, stock XYZ has been rising for more than 10%. Sell if out of the 20 trading days for the past month, stock XYZ has been falling for more than 10%. Follow this rule strictly, return is abnormally high.

Stock price reflects information

If you have spotted such price pattern that seems to guarantee you a sure profit, what should you do? You should definitely exploit it. (How? Borrow as much as you can to invest according to your strategy.) The process of exploiting the pattern actually ironically destroy the pattern because: You would bid up XYZ share price when you think it is hot. Price => Expected[Return] You would bid down XYZ share price when you think it is cold. Price => Expected[Return] The fact that you have figured out a stock price movement is very likely to be reflected by the stock price. The more greedy (which is rational. More precisely, is the higher the ability for you to raise fund) you are, the faster the pattern will be eliminated by your own hands. Bottom line: info, private or public, is reflected in stock prices.

Price movement pattern

Stock Price Investors behaviors tend to eliminate any profit opportunity associated with stock price patterns. Sell Sell Buy Buy If it were possible to make big money simply by finding the pattern in the stock price movements, everyone would have done it and the profits would be competed away.

Time

You are not alone in the market

Imagine not only you, there is essentially an army of intelligent, well-informed security analysts, traders, who literally spend their lives hunting for mispriced securities or securities that follow a pattern based on currently available information. They have high-tech computers, subscription to professional database, up-to-date information on thousands of firms, state-of-the-art analytical technique, etc. These people can assess, assimilate and act on information, very quickly. In their intense search for mispriced securities, professional investors may police the market so efficiently that they drive the prices of all assets to fully reflect all available information.

Implications
Competition for finding mispriced securities is fierce. Such competition always kills the sure-profit pattern. Were there one, it would have been exploited by someone who first spotted it. Thus, roughly speaking, no arbitrage should hold. The first one does make abnormal profit, but Economic profit gross profit The very first one is not likely to be you. Even if you are the very first one, you are likely to pay higher brokerage and commission fees than institutional investors and professional traders The implications: stock prices should have reflected all available information. stock prices should be unpredictable.

Unpredictability
Prices are unpredictable in the sense that stock prices should have reflected all available information. Thus if stock prices change, it should be reacting only to new information. The fact that information is new means stock prices are unpredictable.

Market efficiency
If all past information is incorporated in the price then it should be impossible to consistently beat the market using technical analysis and the like. Definition 1:
Eugene Fama defined Market Efficiency as the state where "security prices reflect all available information.

Definition 2:
Financial markets are efficient if current asset prices fully reflect all currently available relevant information.

The right question to ask

If new information becomes known about a particular company, how quickly do market participants find out about the information and buy or sell the securities of the company based on the information? How quickly do the prices of the securities adjust to reflect the new information? The issue is not merely black or white. We know that the market should neither be strictly efficient nor strictly inefficient. The question is one of degree. We should ask how efficient the market really is?

Subsets of available information for a given stock

All Available Information including inside or private information

All Public Information

Information in past stock prices

3 forms of market efficiency hypothesis

All Available Information including inside or private information

Since we are more interested in how efficient is the capital market, we define the following 3 forms of market efficiency hypothesis: A market is efficient if it reflects ALL available information

All Public Information

Information in past stock prices

[1] Strong-form - ALL available info [2] Semi-strong form

- ALL available info

[3] Weak-form - ALL available info

3 forms of market efficiency hypothesis

Weak-form Stock prices are assumed to reflect any information that may be contained in the past stock prices. For example, suppose there exists a seasonal pattern in stock prices such that stock prices fall on the last trading day of the year and then rise on the first trading day of the following year. Under the weak-form of the hypothesis, the market will come to recognize this and price the phenomenon away. Anticipating the rise in price on the first day of the year, traders will attempt to get in at the very start of trading on the first day. Their attempts to get in will cause the increase in price to occur in the first few minutes of the first day. Intelligent traders will then recognize that to beat the rest of the market, they will have to get in late on the last day. The consequences, therefore, is the elimination of the pattern as price in the last trading day should be bid up.

3 forms of market efficiency hypothesis

Semi-strong-form Stock prices are assumed to reflect any information that is publicly available. These include information on the stock price series, as well as information in the firms accounting reports, the past prices and reports of competing firms, announced information relating to the state of the economy, and any other publicly available information relevant to the valuation of the firm.

3 forms of market efficiency hypothesis

Strong-form Stock prices are assumed to reflect ALL information, regardless of them being public or private. Under this form, those who acquire insider information act on it, buying or selling the stock. Their actions affect the price of the stock, and the price quickly adjusts to reflect the insider information.

3 forms of market efficiency hypothesis

If Weak-form of the hypothesis is valid:
Technical analysis or charting becomes ineffective. You wont be able to gain abnormal returns based on it.

If Semi-strong form of the hypothesis is valid:

No analysis will help you attain abnormal returns as long as the analysis is based on publicly available information.

If Strong-form of the hypothesis is valid:

Any effort to seek out insider information to beat the market are ineffective because the price has already reflected the insider information. Under this form of the hypothesis, the professional investor truly has a zero market value because no form of search or processing of information will consistently produce abnormal returns. (Even if Steve Jobs is your uncle, you cant profit from listening to his phone calls and trading APPLE stocks.)

Expected return-risk
The Efficient Market Hypothesis imposes no structure on stock prices. However, what is abnormal return? Abnormal return = Actual return Expected return This means we have to know what exactly is expected return. Thats why we may rely on an asset pricing model.
e.g.,CAPM, to find a risk-adjusted return that the market will be rewarding.)

Defining abnormal return inherently involves assuming a pricing model. If we find abnormal returns, we conclude that the market is inefficient. But then, we can also say that the pricing model we used is invalid. The challenge here is: testing market efficiency inevitably involves testing a joint hypothesis: H0 : both market is efficient and the pricing model is valid. H1 : EITHER market is inefficient OR the pricing model is invalid.

4 basic traits of efficiency

An efficient market exhibits certain behavioral traits. We can examine the real market to see if it conforms to these traits. If it doesnt, we can conclude that the market is inefficient.
1. 2. 3. 4. Act to new information quickly and accurately Price movement is unpredictable (memory-less) No trading strategy consistently beat the market Investment professionals not that professional

1) Act to news quickly & accurately

Stock price ($)

Days relative to announcement day

-t

0
The timing for a positive news

+t

1) Act to news quickly & accurately

Stock price ($)

Days relative to announcement day

-t
If the market is efficient,

+t

1) at time 0, the positive news come, there is an immediate jump of the share price to the RIGHT level. (i.e., the PINK path) 2) There is no delays in analyzing news and slowly reflecting in the share price like the ORANGE path does. 3) There is also no over-reaction like the BLUE path does, and then subsequently adjustment back to the correct level.

2) Memory-less price movement

If the market is efficient (WEAK-FORM), 1) The so-called momentum is nothing. (Google Stock momentum)

momentum is like, if once started on a downward slide, stock prices develop a propensity to continue sliding. The expected change in todays price would, in fact, be related (correlated positively) with the price changes in the past.

2) If the market is efficient, prices only move in response to news. More precisely, news is any discrepancy between the publics expectation and the actual realized event. E.g, Suppose everyone expects RIMs sales should have gone up by 30%. If RIM does announce that its sales has gone up by 30%, it is not a news. If it has gone up by 29% instead, it is a news, a negative one though. 3) To detect memory or momentum, we try to see if Cov(Pt, Pt-i) is significantly different from zero or not, for i 0

3) No superior trading strategies

One way to test for market efficiency is to test whether a specific trading rule or investment strategy, would have CONSISTENTLY produced abnormally high return. Problem about such test is: 1. What is abnormal return again? We run into the problem of joint hypothesis testing again in order to find an expected return as benchmark.

2. What kind of information you use to construct an investment strategy? Can you be sure the information you are based on really reflect what WAS available when the decision to invest was made.
E.g., Last quarters earning is out around February of next year. If a WINNING investment strategy says invest in the top 10 companies last year by Jan, it is not an employable strategy.

3. What is the cost of implementing a strategy?

4) Professionals arent that professional

If professional investors consistently beat the market, we conclude that the market is not that efficient. If the market is really efficient, we should not see professionals making abnormally high returns. The puzzle is: we do see professionals, like Peter Lynch and Warren Buffet, having amazing records. A defense, a weak one though, is: Suppose we take a thousand people in a gigantic stadium. Have them flip coins. Suppose head is winning and tail is losing. There is no surprise to find a few individual flippers with unbelievable records of success and failure. Those having 20 heads in a row goes on TV and showcase their exceptional flipping skills. But we know theyre just plain lucky.

So whats the value for portfolio management

If capital markets are efficient, should we just throw darts at the financial page to pick stocks instead of spending time carefully construct a stock portfolio? The answer is 3 NO NO NO. As you have learnt, you need to have a well-diversified portfolio that is tailored towards your risk-preference. Depending on your age, your risk-preference, your current situation, your tax bracket, and all other relevant factors, your portfolio should be carefully constructed. Dont forget that there is value for diversification. There is value for you to learn options. There is value for you to tailor a future payoff profile specific to your own needs. Throwing darts to pick stocks does not guarantee your specific needs are met.

So whats the value for portfolio management

The conclusion is: capital market is neither purely efficient nor purely inefficient.

The right question to ask is the degree of efficiency of capital market.

The more efficient capital market is, the better off the society. But even if it is efficient, it doesnt imply knowledge of finance is useless. Because you have learnt diversification and portfolio theory that is based on maximizing happiness. Price movements are random. But it in NO way implies prices are random. Prices reflect/incorporate available information. The driving force to their random movements is that news comes randomly.