Market Efficiency, Behaviroal Finance and Creating Superior Portfolio

8/14/2019 Market Efficiency, Behaviroal Finance and Creating Superior Portfolio

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Market Efficiency and Behavioral Finance

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Efficient Market Hypothesis

(EMH)

Do security prices reflect information ?

Why look at market efficiency?

Implications for business and corporate

finance

Implications for investment

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Random Walk and the

EMHRandom Walk - stock prices are random

Actually submartingale Expected price is positive over time

Positive trend and random about the trend

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SecurityPrices

Time

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Random Price ChangesWhy are price changes random?

Prices react to information

Flow of information is random

Therefore, price changes are random

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EMH and CompetitionStock prices fully and accurately reflect

publicly available information.Once information becomes available,

market participants analyze it.

Competition assures prices reflect

information.

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Forms of the EMH Weak

Semi-strong

Strong

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Types of Stock AnalysisTechnical 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 & fundamentalanalysis

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Active or Passive

ManagementActive Management

Security analysis

Timing

Passive Management

Buy and HoldIndex Funds

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Empirical Tests of Market

EfficiencyEvent studies

Assessing performance of professionalmanagers

Testing some trading rule

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How Tests Are Structured1. Examine prices and returns over time

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0 +t-t

Announcement Date

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How Tests Are Structured

(contd)2. Returns are adjusted to determine if they areabnormal.

Market Model approach

a. Rt= a

t+ b

tR

mt+ e

t

(Expected Return)

b. Excess Return =

(Actual - Expected)

et= Actual - (a

t+ b

tR

mt)

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How Tests Are Structured

(contd)2. Returns are adjusted to determine if they are

abnormal.

Market Model approachc. Cumulate the excess returns overtime:

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Issues in Examining the

ResultsMagnitude Issue

Selection Bias Issue

Lucky Event Issue

Possible Model Misspecification

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What Does the Evidence

Show?Technical Analysis

Short horizon

Long horizon

Fundamental Analysis

Anomalies Exist

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AnomaliesSmall Firm Effect (January Effect)

Neglected Firm

Market to Book Ratios

Reversals

Post-Earnings Announcement Drift

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Explanations of

AnomaliesMay be risk premiums

Behavioral Explanations

Information Processing Errors

Behavioral BiasesLimits to Arbitrage

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Information ProcessingForecasting Errors

Overconfidence

Conservatism

Sample Neglect and Representativeness

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Behavioral BiasesAnchoring

Mental Accounting

Confirmation & Hindsight bias

Gamblers fallacyHear behaviour

Over confidence

Overreaction and availability bias

Prospect theory

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Limits to ArbitrageFundamental Risk

Implementation Costs

Model Risk

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Mutual Fund PerformanceSome evidence of persistent positive and

negative performance.

Potential measurement error forbenchmark returns.

Style changes

May be risk premiums

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Market Efficiency, Behaviroal Finance and Creating Superior Portfolio

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