9.0 Efficient Market

Chapter 9
Efficient Markets and Behavioural Finance
Contents
Efficient Markets and Behavioural Finance...........................................................................................1
9.1 What is an Efficient Market?...........................................................................................................1
9.1.1 Random Walk Theory...............................................................................................................1
What is the 'Random Walk Theory'...................................................................................................1
9.1.2 Efficient market Hypothesis......................................................................................................1
9.1.2.1 Three forms of Market efficiency.......................................................................................2
9.2 The Evidence against Market Efficiency...........................................................................................3
9.3 Behavioural Finance........................................................................................................................3
9.4 The Five Lessons of Market Efficiency.............................................................................................4
9.1 What is an Efficient Market?
9.1.1 Random Walk Theory
What is the 'Random Walk Theory'

The random walk theory suggests that changes in stock prices have the same distribution
and are independent of each other, therefore, the past movement or trend of a stock price
or market cannot be used to predict its future movement. In short, this is the idea that
stocks take a random and unpredictable path.
Read more: Random Walk

Theory https://www.investopedia.com/terms/r/randomwalktheory.asp#ixzz5XSMydT4c
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9.1.2 Efficient market Hypothesis
According to the EMH, stocks always trade at their fair value on stock exchanges, making it
impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As
such, it should be impossible to outperform the overall market through expert stock selection
1
or market timing, and the only way an investor can possibly obtain higher returns is by purchasing
riskier investments.
Believers argue it is pointless to search for undervalued stocks or to try to predict trends in the
market through either fundamental or technical analysis.
Read more: Efficient Market Hypothesis

(EMH) https://www.investopedia.com/terms/e/efficientmarkethypothesis.asp#ixzz5XSMd9IXX
9.1.2.1 Three forms of Market efficiency
The Three Basic Forms of the EMH

The efficient market hypothesis assumes that markets are efficient. However, the efficient market
hypothesis (EMH) can be categorized into three basic levels:
1. Weak-Form EMH
The weak-form EMH implies that the market is efficient, reflecting all market information. This
hypothesis assumes that the rates of return on the market should be independent; past rates of
return have no effect on future rates. Given this assumption, rules such as the ones traders use to
buy or sell a stock, are invalid.
2. Semi-Strong EMH
The semi-strong form EMH implies that the market is efficient, reflecting all publicly available
information. This hypothesis assumes that stocks adjust quickly to absorb new information. The
semi-strong form EMH also incorporates the weak-form hypothesis. Given the assumption that
stock prices reflect all new available information and investors purchase stocks after this
information is released, an investor cannot benefit over and above the market by trading on new
information.
3. Strong-Form EMH
The strong-form EMH implies that the market is efficient: it reflects all information both public and
private, building and incorporating the weak-form EMH and the semi-strong form EMH. Given the
assumption that stock prices reflect all information (public as well as private) no investor would be
able to profit above the average investor even if he was given new information.
Read more: Weak, Semi-Strong and Strong EMH https://www.investopedia.com/exam-guide/cfa-

level-1/securities-markets/weak-semistrong-strong-emh-efficient-market-
hypothesis.asp#ixzz5XSP6HSJ3
2
9.2 The Evidence against Market Efficiency
Criticisms of Efficient Market Hypothesis.
Stock Prices often reflect evidence of:
 Irrational exuberance – people getting carried away by booms and asset bubbles
(e.g. US house prices in 2000s, Dot Com Bubble and Bust.
 Behavioural economics places greater emphasis on the irrationality of human
behaviour in making economic decisions e.g. herding effect e.t.c
9.3 Behavioural Finance
Behavioral finance, a sub-field of behavioral economics, proposes psychology-based theories to

explain stock market anomalies, such as severe rises or falls in stock price.
Read more: Behavioral
Finance https://www.investopedia.com/terms/b/behavioralfinance.asp#ixzz5XSaYeFTH
Why might prices depart from fundamental values? Some believe that the answer lies in behavioural
psychology.
• Factors Relating Efficiency and Psychology

• Attitudes toward risk
- Investor do not focus solely on the current value of their holdings,
but look back at whether their investments are showing profit or a
loss
• Beliefs about probabilities

- When judging possible future outcomes, individuals tend to
look back at what happened in a few similar situations
• Limits to Arbitrage
-Arbitrageur buys under-priced and sell overpriced stocks, so it will push back the
prices to the true value. However, it may not happen due to concern of trading costs and to
avoid future loss due to wrong decisions.
3
• Incentive Problems and the Subprime Crisis
- Institutions and players have their own interests
- In subprime crisis, US property markets have a boom and
suddenly crash in 2007. Some of the main reasons of the crash
are due to banks, credit rating agencies and other financial
institutions all had distorted incentive.
- The same case happens in stock market where some of the
mutual fund managers have their own interest which could lead
to mispricing and potentially bubbles.
(Brealey et al page 333-335)
9.4 The Six Lessons of Market Efficiency
• Markets Have No Memory

- Past price changes contain no information about future
changes.
- Information will influence the price movement
• Trust Market Prices
- In an efficient market you can trust prices, for they impound all
available information about the value of each security
- This means that in an efficient market, there is no way for most
investors to achieve consistently superior rates of return.
• Read the Entrails

- If the market is efficient, prices impound all available
information.
- Therefore, if we can only learn to read the entrails, security
prices can tell us a lot about the future
- E.g. if a company’s bonds trading at a very low prices and the
stock prices on downward trend, you can deduce that the firm is
probably in trouble
• There are No Financial Illusions

- The main concern of investors is the firm’s cash flow
- creative accounting done by the managers to boost their short-
term earnings will not influence investors as they see beyond
accounting figures
4
• Remember the Do-It-Yourself Alternative
- In efficient market investors will not pay others for what they
can do equally
- E.g. reason of companies exercising M& A is to diversified
risk. However, investors can diversify themselves for their risk.
If the diversification benefits of M & A exercise are not higher
than the investors diversification strategy, they will sell the
shares.
- E.g. company issue debt. Investors will sell their share if the
risk they bear higher than the tax shield benefits
• Seen One Stock, Seen Them All
- Investors don’t buy a stock for its unique qualities, they buy it
because it offers the prospect of a fair return for its risk.
- The demand for a company’s stock is highly elastic. If its
prospective return is too low relative to its risk, nobody will
want to hold that stock, vice versa
-
(Brealey et al page 336-340)

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Chapter 9

Efficient Markets and Behavioural Finance

9.1 What is an Efficient Market?

9.1.1 Random Walk Theory

What is the 'Random Walk Theory'

Read more: Random Walk

9.1.2 Efficient market Hypothesis

Read more: Efficient Market Hypothesis

9.1.2.1 Three forms of Market efficiency

The Three Basic Forms of the EMH

Read more: Weak, Semi-Strong and Strong EMH https://www.investopedia.com/exam-guide/cfa-

Criticisms of Efficient Market Hypothesis.

Stock Prices often reflect evidence of:

9.3 Behavioural Finance

Behavioral finance, a sub-field of behavioral economics, proposes psychology-based theories to

• Factors Relating Efficiency and Psychology

• Beliefs about probabilities

9.4 The Six Lessons of Market Efficiency

• Markets Have No Memory

• Read the Entrails

• There are No Financial Illusions

• Seen One Stock, Seen Them All

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