This document summarizes key aspects of the efficient market hypothesis. It provides examples testing whether markets are efficient, including: correlations between stock returns over time, Microsoft's continuing profits, and the book-to-market effect. It also discusses whether anomalies like the size effect mean markets are inefficient. While some patterns in returns seem predictable, the document argues this does not disprove efficiency, as statistical significance does not necessarily imply economic significance. Over the long run, upward drift in stock prices is expected as economies tend to grow.
This document summarizes key aspects of the efficient market hypothesis. It provides examples testing whether markets are efficient, including: correlations between stock returns over time, Microsoft's continuing profits, and the book-to-market effect. It also discusses whether anomalies like the size effect mean markets are inefficient. While some patterns in returns seem predictable, the document argues this does not disprove efficiency, as statistical significance does not necessarily imply economic significance. Over the long run, upward drift in stock prices is expected as economies tend to grow.
This document summarizes key aspects of the efficient market hypothesis. It provides examples testing whether markets are efficient, including: correlations between stock returns over time, Microsoft's continuing profits, and the book-to-market effect. It also discusses whether anomalies like the size effect mean markets are inefficient. While some patterns in returns seem predictable, the document argues this does not disprove efficiency, as statistical significance does not necessarily imply economic significance. Over the long run, upward drift in stock prices is expected as economies tend to grow.
PROBLEM SETS 1. The correlation coefficient beteen !toc" ret#rn! for to nono$erla%%in& %erio'! !ho#l' be (ero. If not) ret#rn! fro* one %erio' co#l' be #!e' to %re'ict ret#rn! in later %erio'! an' *a"e abnor*al %rofit!. +. No. Micro!oft,! contin#in& %rofitabilit- 'oe! not i*%l- that !toc" *ar"et in$e!tor! ho %#rcha!e' Micro!oft !hare! after it! !#cce!! a! alrea'- e$i'ent o#l' ha$e earne' an e.ce%tionall- hi&h ret#rn on their in$e!t*ent!. It !i*%l- *ean! that Micro!oft ha! *a'e ri!"- in$e!t*ent! o$er the -ear! that ha$e %ai' off in the for* of increa!e' ca!h flo! an' %rofitabilit-. Micro!oft !harehol'er! ha$e benefite' fro* the ri!"/e.%ecte' ret#rn tra'eoff) hich i! con!i!tent ith the EMH. 0. E.%ecte' rate! of ret#rn 'iffer beca#!e of 'ifferential ri!" %re*i#*! acro!! all !ec#ritie!. 1. No. The $al#e of 'i$i'en' %re'ictabilit- o#l' be alrea'- reflecte' in the !toc" %rice. 2. No) *ar"et! can be efficient e$en if !o*e in$e!tor! earn ret#rn! abo$e the *ar"et a$era&e. Con!i'er the 3#c"- E$ent i!!#e: I&norin& tran!action co!t!) abo#t 245 of %rofe!!ional in$e!tor!) b- 'efinition) ill 6beat7 the *ar"et in an- &i$en -ear. The %robabilit- of beatin& it three -ear! in a ro) tho#&h !*all) i! not in!i&nificant. 8eatin& the *ar"et in the %a!t 'oe! not %re'ict f#t#re !#cce!! a! three -ear! of ret#rn! *a"e #% too !*all a !a*%le on hich to ba!e correlation let alone ca#!ation. 9. :olatile !toc" %rice! co#l' reflect $olatile #n'erl-in& econo*ic con'ition! a! lar&e a*o#nt! of infor*ation bein& incor%orate' into the %rice ill ca#!e $ariabilit- in !toc" %rice. The efficient *ar"et h-%othe!i! !#&&e!t! that in$e!tor! cannot earn e.ce!! ri!"/a';#!te' rear'!. The $ariabilit- of the !toc" %rice i! th#! reflecte' in the e.%ecte' ret#rn! a! ret#rn! an' ri!" are %o!iti$el- correlate'. <. The folloin& effect! !ee* to !#&&e!t %re'ictabilit- ithin e=#it- *ar"et! an' th#! 'i!%ro$e the efficient *ar"et h-%othe!i!. Hoe$er) con!i'er the folloin&: a. M#lti%le !t#'ie! !#&&e!t that 6$al#e7 !toc"! >*ea!#re' often b- lo P?E *#lti%le!@ earn hi&her ret#rn! o$er ti*e than 6&roth7 !toc"! >hi&h P?E *#lti%le!@. Thi! co#l' !#&&e!t a !trate&- for earnin& hi&her ret#rn! o$er ti*e. Hoe$er) another 11/1 CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS rational ar&#*ent *a- be that tra'itional for*! of CAPM >!#ch a! Shar%e,! *o'el@ 'o not f#ll- acco#nt for all ri!" factor! that affect a fir*,! %rice le$el. A fir* $iee' a! ri!"ier *a- ha$e a loer %rice an' th#! P?E *#lti%le. b. The boo"/to/*ar"et effect !#&&e!t! that an in$e!tor can earn e.ce!! ret#rn! b- in$e!tin& in co*%anie! ith hi&h boo" $al#e >the $al#e of a fir*,! a!!et! *in#! it! liabilitie! 'i$i'e' b- the n#*ber of !hare! o#t!tan'in&@ to *ar"et $al#e. A !t#'- b- Fa*a an' French 1 !#&&e!t! that boo"/to/*ar"et $al#e reflect! a ri!" factor that i! not acco#nte' for b- tra'itional one $ariable CAPM. For e.a*%le) co*%anie! e.%eriencin& financial 'i!tre!! !ee the ratio of boo" to *ar"et $al#e increa!e. Th#! a *ore co*%le. CAPM that incl#'e! boo"/to/*ar"et $al#e a! an e.%lanator- $ariable !ho#l' be #!e' to te!t *ar"et ano*alie!. c. Stoc" %rice *o*ent#* can be %o!iti$el- correlate' ith %a!t %erfor*ance >!hort to inter*e'iate hori(on@ or ne&ati$el- correlate' >lon& hori(on@. Hi!torical 'ata !ee* to i*%l- !tati!tical !i&nificance to the!e %attern!. E.%lanation! for thi! incl#'e a ban'a&on effect or the beha$iori!t!, >!ee Cha%ter 1+@ e.%lanation that there i! a ten'enc- for in$e!tor! to #n'erreact to ne infor*ation) th#! %ro'#cin& a %o!iti$e !erial correlation. Hoe$er) !tati!tical !i&nificance 'oe! not i*%l- econo*ic !i&nificance. Se$eral !t#'ie! that incl#'e' tran!action co!t! in the *o*ent#* *o'el! 'i!co$ere' that *o*ent#* tra'er! ten'e' to not o#t%erfor* the efficient *ar"et h-%othe!i! !trate&- of b#- an' hol'. '. The !*all/fir* effect !tate! that !*aller fir*! %ro'#ce better ret#rn! than lar&er fir*!. Since 1A+9) ret#rn! fro* !*all fir*! o#t%ace lar&e fir* !toc" ret#rn! b- abo#t 15 %er -ear. Bo !*all ca% in$e!tor! earn e.ce!! ri!"/a';#!te' ret#rn!C The *ea!#re of !-!te*atic ri!" accor'in& to Shar%e,! CAPM i! the !toc",! beta >or !en!iti$it- of ret#rn! of the !toc" to *ar"et ret#rn!@. If the !toc",! beta i! the be!t e.%lanation of ri!") then the !*all/fir* effect 'oe! in'icate an inefficient *ar"et. Bi$i'in& the *ar"et into 'ecile! ba!e' on their beta! !ho! an increa!in& relation!hi% beteen beta! an' ret#rn!. Fa*a an' French + !ho that the e*%irical relation!hi% beteen beta an' !toc" ret#rn! i! flat o$er a fairl- lon& hori(on >1A90D 1AA4@. 8rea"in& the *ar"et into 'ecile! ba!e' on !i(e! an' then e.a*inin& the relation!hi% beteen beta an' !toc" ret#rn! ithin each !i(e 'ecile e.hibit! thi! flat relation!hi%. Thi! i*%lie! that fir* !i(e *a- be a better *ea!#re of ri!" than beta an' the !i(e/effect !ho#l' not be $iee' a! an in'icator that *ar"et! are inefficient. He#ri!ticall- thi! *a"e! !en!e) a! !*aller fir*! are &enerall- $iee' a! ri!"- co*%are' to lar&er fir*! an' %ercei$e' ri!" an' ret#rn are %o!iti$el- correlate'. In a''ition thi! effect !ee*! to be en'%oint an' 'ata !en!iti$e. For e.a*%le) !*aller !toc"! 'i' not o#t%erfor* lar&er !toc"! fro* the *i'/1AE4! thro#&h the 1AA4!. In a''ition) 'ataba!e! contain !toc" ret#rn! fro* co*%anie! that ha$e !#r$i$e' an' 'o 1 Fama, Eugene and Kenneth French, Common Risk Factors in the Returns on Stocks and Bonds, Journal of Finance 33:1, pp. 3-56. 2 Ibid 11/+ CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS not incl#'e ret#rn! of tho!e that ent ban"r#%t. Th#! !*all/fir* 'ata *a- e.hibit !#r$i$or!hi% bia!. E. O$er the lon& ha#l) there i! an e.%ecte' #%ar' 'rift in !toc" %rice! ba!e' on their fair e.%ecte' rate! of ret#rn. The fair e.%ecte' ret#rn o$er an- !in&le 'a- i! $er- !*all >e.&.) 1+5 %er -ear i! onl- abo#t 4.405 %er 'a-@) !o that on an- 'a- the %rice i! $irt#all- e=#all- li"el- to ri!e or fall. O$er lon&er %erio'!) the !*all e.%ecte' 'ail- ret#rn! acc#*#late) an' #%ar' *o$e! are *ore li"el- than 'onar' one!. Re*e*ber that econo*ie! ten' to &ro o$er ti*e an' !toc" %rice! ten' to follo econo*ic &roth) !o it i! onl- nat#ral that there i! an #%ar' 'rift in e=#it- %rice!. A. c. Thi! i! a %re'ictable %attern in ret#rn! that !ho#l' not occ#r if the ea"/for* EMH i! $ali'. 14. a. Ac#te *ar"et inefficiencie! are te*%orar- in nat#re an' are *ore ea!il- e.%loite' than chronic inefficiencie!. A te*%orar- 'ro% in a !toc" %rice '#e to a lar&e !ale o#l' be *ore ea!il- e.%loite' than the chronic inefficiencie! *entione' in the other re!%on!e!. 11. c. Thi! i! a cla!!ic filter r#le that !ho#l' not %ro'#ce !#%erior ret#rn! in an efficient *ar"et. 1+. b. Thi! i! the 'efinition of an efficient *ar"et. 10. a. Tho#&h !toc" %rice! follo a ran'o* al" an' intra'a- %rice chan&e! 'o a%%ear to be a ran'o* al") o$er the lon& r#n there i! co*%en!ation for bearin& *ar"et ri!" an' for the ti*e $al#e of *one-. In$e!tin& 'iffer! fro* a ca!ino in that in the lon&/r#n) an in$e!tor i! co*%en!ate' for the!e ri!"!) hile a %la-er at a ca!ino face! le!! than fair/&a*e o''!. b. In an efficient *ar"et) an- %re'ictable f#t#re %ro!%ect! of a co*%an- ha$e alrea'- been %rice' into the c#rrent $al#e of the !toc". Th#!) a !toc" !hare %rice can !till follo a ran'o* al". c. Fhile the ran'o* nat#re of 'art boar' !election !ee*! to follo nat#rall- fro* efficient *ar"et!) the role of rational %ortfolio *ana&e*ent !till e.i!t!. It e.i!t! to en!#re a ell/'i$er!ifie' %ortfolio) to a!!e!! the ri!"/tolerance of the in$e!tor) an' to ta"e into acco#nt ta. co'e i!!#e!. 11. '. In a !e*i!tron&/for* efficient *ar"et) it i! not %o!!ible to earn abnor*all- hi&h %rofit! b- tra'in& on %#blicl- a$ailable infor*ation. Infor*ation abo#t P?E 11/0 CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS ratio! an' recent %rice chan&e! i! %#blicl- "non. On the other han') an in$e!tor ho ha! a'$ance "nole'&e of *ana&e*ent i*%ro$e*ent! co#l' earn abnor*all- hi&h tra'in& %rofit! >#nle!! the *ar"et i! al!o !tron&/for* efficient@. 12. Mar"et efficienc- i*%lie! in$e!tor! cannot earn e.ce!! ri!"/a';#!te' %rofit!. If the !toc" %rice r#n/#% occ#r! hen onl- in!i'er! "no of the co*in& 'i$i'en' increa!e) then it i! a $iolation of !tron&/for* efficienc-. If the %#blic al!o "no! of the increa!e) then thi! $iolate! !e*i!tron&/for* efficienc-. 19. Fhile %o!iti$e beta !toc"! re!%on' ell to fa$orable ne infor*ation abo#t the econo*-,! %ro&re!! thro#&h the b#!ine!! c-cle) the- !ho#l' not !ho abnor*al ret#rn! aro#n' alrea'- antici%ate' e$ent!. If a reco$er-) for e.a*%le) i! alrea'- antici%ate') the act#al reco$er- i! not ne!. The !toc" %rice !ho#l' alrea'- reflect the co*in& reco$er-. 1<. a. Con!i!tent. 8a!e' on %#re l#c") half of all *ana&er! !ho#l' beat the *ar"et in an- -ear. b. Incon!i!tent. Thi! o#l' be the ba!i! of an 6ea!- *one-7 r#le: !i*%l- in$e!t ith la!t -earG! be!t *ana&er!. c. Con!i!tent. In contra!t to %re'ictable ret#rn!) %re'ictable volatility 'oe! not con$e- a *ean! to earn abnor*al ret#rn!. '. Incon!i!tent. The abnor*al %erfor*ance o#&ht to occ#r in Han#ar- hen earnin&! are anno#nce'. e. Incon!i!tent. Re$er!al! offer a *ean! to earn ea!- *one-: ;#!t b#- la!t ee",! lo!er!. 1E. The ret#rn on the *ar"et i! E5. Therefore) the foreca!t *onthl- ret#rn for For' i!: 4.145 I >1.1 J E5@ K E.A5 For',! act#al ret#rn a! <5) !o the abnor*al ret#rn a! D1.A5. 1A. a. 8a!e' on broa' *ar"et tren'!) the CAPM in'icate! that A*bCha!er !toc" !ho#l' ha$e increa!e' b-: 1.45 I +.4 J >1.25 D 1.45@ K +.45 It! fir*/!%ecific >non!-!te*atic@ ret#rn '#e to the la!#it i! L1 *illion %er L144 *illion initial e=#it-) or 15. Therefore) the total ret#rn !ho#l' be 05. >It i! a!!#*e' here that the o#tco*e of the la!#it ha' a (ero e.%ecte' $al#e.@ 11/1 CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS b. If the !ettle*ent a! e.%ecte' to be L+ *illion) then the act#al !ettle*ent a! a 6L1 *illion 'i!a%%oint*ent)7 an' !o the fir*/!%ecific ret#rn o#l' be D15) for a total ret#rn of +5 D 15 K 15. +4. Mi$en *ar"et %erfor*ance) %re'icte' ret#rn! on the to !toc"! o#l' be: A%e.: 4.+5 I >1.1 J 05@ K 1.15 8%e.: D4.15 I >4.9 J 05@ K 1.<5 A%e. #n'er%erfor*e' thi! %re'ictionN 8%e. o#t%erfor*e' the %re'iction. Fe concl#'e that 8%e. on the la!#it. +1. a. E>rM @ K 1+5) rf K 15 an' O K 4.2 Therefore) the e.%ecte' rate of ret#rn i!: 15 I 4.2 J >1+5 D 15@ K E5 If the !toc" i! fairl- %rice') then E>r@ K E5. b. If rM fall! !hort of -o#r e.%ectation b- +5 >that i!) 145 D 1+5@ then -o# o#l' e.%ect the ret#rn for Chan&in& Fort#ne! In'#!trie! to fall !hort of -o#r ori&inal e.%ectation b-: O J +5 K 15 Therefore) -o# o#l' foreca!t a re$i!e' e.%ectation for Chan&in& Fort#ne! of: E5 D 15 K <5 c. Mi$en a *ar"et ret#rn of 145) -o# o#l' foreca!t a ret#rn for Chan&in& Fort#ne! of <5. The act#al ret#rn i! 145. Therefore) the !#r%ri!e '#e to fir*/ !%ecific factor! i! 145 D <5 K 05) hich e attrib#te to the !ettle*ent. 8eca#!e the fir* i! initiall- orth L144 *illion) the !#r%ri!e a*o#nt of the !ettle*ent i! 05 of L144 *illion) or L0 *illion) i*%l-in& that the %rior e.%ectation for the !ettle*ent a! onl- L+ *illion. ++. I*%licit in the 'ollar/co!t a$era&in& !trate&- i! the notion that !toc" %rice! fl#ct#ate aro#n' a 6nor*al7 le$el. Otheri!e) there i! no *eanin& to !tate*ent! !#ch a!: 6hen the %rice i! hi&h.7 Ho 'o e "no) for e.a*%le) hether a %rice of L+2 to'a- ill t#rn o#t to be $iee' a! hi&h or lo co*%are' to the !toc" %rice !i. *onth! fro* noC +0. The *ar"et re!%on'! %o!iti$el- to new ne!. If the e$ent#al reco$er- i! antici%ate') then the reco$er- i! alrea'- reflecte' in !toc" %rice!. Onl- a better/than/e.%ecte' reco$er- !ho#l' affect !toc" %rice!. +1. 8#-. In -o#r $ie) the fir* i! not a! ba' a! e$er-one el!e belie$e! it to be. Therefore) -o# $ie the fir* a! #n'er$al#e' b- the *ar"et. Yo# are le!! %e!!i*i!tic abo#t the fir*,! %ro!%ect! than the belief! b#ilt into the !toc" %rice. 11/2 CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS +2. Here e nee' a to/factor *o'el relatin& For',! ret#rn to tho!e of both the broa' *ar"et an' the a#to in'#!tr-. If e call rI the in'#!tr- ret#rn) then e o#l' fir!t e!ti*ate %ara*eter! P)O )O M IND in the folloin& re&re!!ion: FORB P O O Q M M IND IND r r r = + + + Mi$en the!e e!ti*ate! e o#l' calc#late For',! fir*/!%ecific ret#rn a!: FORB RP O O QS M M IND IND r r r + + + Thi! e!ti*ate of fir*/!%ecific ne! o#l' *ea!#re the *ar"et,! a!!e!!*ent of the %otential %rofitabilit- of For',! ne *o'el. +9. The *ar"et *a- ha$e antici%ate' e$en &reater earnin&!. Compared to prior expectations, the anno#nce*ent a! a 'i!a%%oint*ent. +<. Thinl- tra'e' !toc"! ill not ha$e a con!i'erable a*o#nt of *ar"et re!earch %erfor*e' on the co*%anie! the- re%re!ent. Thi! ne&lecte'/fir* effect i*%lie! a &reater 'e&ree of #ncertaint- ith re!%ect to !*aller co*%anie!. Th#! %o!iti$e CAPM al%ha! a*on& thinl- tra'e' !toc"! 'o not nece!!aril- $iolate the efficient *ar"et h-%othe!i! !ince the!e hi&her al%ha! are act#all- ri!" %re*i#*!) not *ar"et inefficiencie!. +E. The ne&ati$e abnor*al ret#rn! >'onar' 'rift in CAR@ ;#!t %rior to !toc" %#rcha!e! !#&&e!t that in!i'er! 'eferre' their %#rcha!e! #ntil after ba' ne! a! relea!e' to the %#blic. Thi! i! e$i'ence of $al#able in!i'e infor*ation. The %o!iti$e abnor*al ret#rn! after %#rcha!e !#&&e!t in!i'er %#rcha!e! in antici%ation of &oo' ne!. The anal-!i! i! !-**etric for in!i'er !ale!. +A. a. The *ar"et ri!" %re*i#* *o$e! co#nterc-clical to the econo*-) %ea"in& in rece!!ion!. A $iolation of the efficient *ar"et h-%othe!i! o#l' i*%l- that in$e!tor! co#l' ta"e a'$anta&e of thi! %re'ictabilit- an' earn e.ce!! ri!" a';#!te' ret#rn!. Hoe$er) !e$eral !t#'ie!) incl#'in& Sie&el) 0 !ho that !#cce!!f#ll- ti*in& the chan&e! ha$e el#'e' %rofe!!ional in$e!tor! th#! far. Moreo$er a chan&in& ri!" %re*i#* i*%lie! chan&in& re=#ire' rate! of ret#rn for !toc"! rather than an inefficienc- ith the *ar"et. b. A! the *ar"et ri!" %re*i#* increa!e! '#rin& a rece!!ion) !toc"! %rice! ten' to fall. A! the econo*- reco$er!) the *ar"et ri!" %re*i#* fall!) an' !toc" %rice! ten' to ri!e. The!e chan&e! co#l' &i$e in$e!tor! the i*%re!!ion that *ar"et! o$erreact) 0 Here*- Sie&el) Stocks for the Long !n" #he Definitive $!ide to %inancial Market et!rns and Long&#erm Investment Strategies) +44+) Ne Yor": McMra/Hill. 11/9 CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS e!%eciall- if the #n'erl-in& chan&e! in the *ar"et ri!" %re*i#* are !*all b#t c#*#lati$e. For e.a*%le) the October Cra!h of 1AE< i! co**onl- $iee' a! an e.a*%le of *ar"et o$erreaction. Hoe$er) in the ee"! r#nnin& #% to *i'/October) !e$eral #n'erl-in& chan&e! to the *ar"et ri!" %re*i#* occ#rre' >in a''ition to chan&e! in the -iel'! on lon&/ter* Trea!#r- 8on'!@. Con&re!! threatene' in$e!tor! ith a 6*er&er ta.7 that o#l' ha$e tr#ncate' the boo*in& *er&er in'#!tr- an' loo!ene' the 'i!ci%line that the threat of *er&er! %ro$i'e! to a fir*,! *ana&e*ent. In a''ition) the Secretar- of Trea!#r- threatene' f#rther 'e%reciation in the $al#e of the 'ollar) fri&htenin& forei&n in$e!tor!. The!e e$ent! *a- ha$e increa!e' the *ar"et ri!" %re*i#* an' loere' !toc" %rice! in a !ee*in& o$erreaction. CFA PROBLEMS 1. b. Se*i!tron& for* efficienc- i*%lie! that *ar"et %rice! reflect all p!'licly availa'le infor*ation concernin& %a!t tra'in& hi!tor- a! ell a! f#n'a*ental a!%ect! of the fir*. +. a. The f#ll %rice a';#!t*ent !ho#l' occ#r ;#!t a! the ne! abo#t the 'i$i'en' beco*e! %#blicl- a$ailable. 0. '. If lo P?E !toc"! ten' to ha$e %o!iti$e abnor*al ret#rn!) thi! o#l' re%re!ent an #ne.%loite' %rofit o%%ort#nit- that o#l' %ro$i'e e$i'ence that in$e!tor! are not #!in& all a$ailable infor*ation to *a"e %rofitable in$e!t*ent!. 1. c. In an efficient *ar"et) no !ec#ritie! are con!i!tentl- o$er%rice' or #n'er%rice'. Fhile !o*e !ec#ritie! ill t#rn o#t after an- in$e!t*ent %erio' to ha$e %ro$i'e' %o!iti$e al%ha! >i.e.) ri!"/a';#!te' abnor*al ret#rn!@ an' !o*e ne&ati$e al%ha!) the!e %a!t ret#rn! are not %re'icti$e of f#t#re ret#rn!. 2. c. A ran'o* al" i*%lie! that !toc" %rice chan&e! are #n%re'ictable) #!in& %a!t %rice chan&e! or an- other 'ata. 9. '. A &ra'#al a';#!t*ent to f#n'a*ental $al#e! o#l' allo for the #!e of !trate&ie! ba!e' on %a!t %rice *o$e*ent! in or'er to &enerate abnor*al %rofit!. <. a. E. a. So*e e*%irical e$i'ence that !#%%ort! the EMH: >i@ Profe!!ional *one- *ana&er! 'o not t-%icall- earn hi&her ret#rn! than co*%arable ri!") %a!!i$e in'e. !trate&ie!. 11/< CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS >ii@ E$ent !t#'ie! t-%icall- !ho that !toc"! re!%on' i**e'iatel- to the %#blic relea!e of rele$ant ne!. >iii@ Mo!t te!t! of technical anal-!i! fin' that it i! 'iffic#lt to i'entif- %rice tren'! that can be e.%loite' to earn !#%erior ri!"/a';#!te' in$e!t*ent ret#rn!. b. So*e e$i'ence that i! 'iffic#lt to reconcile ith the EMH concern! !i*%le %ortfolio !trate&ie! that a%%arentl- o#l' ha$e %ro$i'e' hi&h ri!"/a';#!te' ret#rn! in the %a!t. So*e e.a*%le! of %ortfolio! ith attracti$e hi!torical ret#rn!: >i@ 3o P?E !toc"!. >ii@ Hi&h boo"/to/*ar"et ratio !toc"!. >iii@ S*all fir*! in Han#ar-. >i$@ Fir*! ith $er- %oor !toc" %rice %erfor*ance in the la!t fe *onth!. Other e$i'ence concern! %o!t/earnin&!/anno#nce*ent !toc" %rice 'rift an' inter*e'iate/ter* %rice *o*ent#*. c. An in$e!tor *i&ht choo!e not to in'e. e$en if *ar"et! are efficient beca#!e he or !he *a- ant to tailor a %ortfolio to !%ecific ta. con!i'eration! or to !%ecific ri!" *ana&e*ent i!!#e!) for e.a*%le) the nee' to he'&e >or at lea!t not a'' to@ e.%o!#re to a %artic#lar !o#rce of ri!" >e.&.) in'#!tr- e.%o!#re@. A. a. The efficient *ar"et h-%othe!i! >EMH@ !tate! that a *ar"et i! efficient if !ec#rit- %rice! i**e'iatel- an' f#ll- reflect all a$ailable rele$ant infor*ation. If the *ar"et f#ll- reflect! infor*ation) the "nole'&e of that infor*ation o#l' not allo an in$e!tor to %rofit fro* the infor*ation beca#!e !toc" %rice! alrea'- incor%orate the infor*ation. i. The weak form of the EMH a!!ert! that !toc" %rice! reflect all the infor*ation that can be 'eri$e' b- e.a*inin& *ar"et tra'in& 'ata !#ch a! the hi!tor- of %a!t %rice! an' tra'in& $ol#*e. A !tron& bo'- of e$i'ence !#%%ort! ea"/for* efficienc- in the *a;or T.S. !ec#ritie! *ar"et!. For e.a*%le) te!t re!#lt! !#&&e!t that technical tra'in& r#le! 'o not %ro'#ce !#%erior ret#rn! after a';#!tin& for tran!action co!t! an' ta.e!. ii. The semistrong form !tate! that a fir*,! !toc" %rice reflect! all %#blicl- a$ailable infor*ation abo#t a fir*,! %ro!%ect!. E.a*%le! of %#blicl- a$ailable infor*ation are co*%an- ann#al re%ort! an' in$e!t*ent a'$i!or- 'ata. E$i'ence !tron&l- !#%%ort! the notion of !e*i!tron& efficienc-) b#t occa!ional !t#'ie! >e.&.) i'entif-in& *ar"et ano*alie! !#ch a! the !*all/fir*/in/Han#ar- or boo"/to/*ar"et effect!@ an' e$ent! >e.&. !toc" *ar"et cra!h of October 1A) 1AE<@ are incon!i!tent ith thi! for* of *ar"et efficienc-. There i! a =#e!tion concernin& the e.tent to hich the!e 6ano*alie!7 re!#lt fro* 'ata *inin&. iii. The strong form of the EMH hol'! that c#rrent *ar"et %rice! reflect all infor*ation >hether %#blicl- a$ailable or %ri$atel- hel'@ that can be rele$ant to the $al#ation of the fir*. 11/E CHAPTER 11: THE EFFICIENT MARKET HYPOTHESIS E*%irical e$i'ence !#&&e!t! that !tron&/for* efficienc- 'oe! not hol'. If thi! for* ere correct) %rice! o#l' f#ll- reflect all infor*ation. Therefore e$en in!i'er! co#l' not earn e.ce!! ret#rn!. 8#t the e$i'ence i! that cor%orate officer! 'o ha$e acce!! to %ertinent infor*ation lon& eno#&h before %#blic relea!e to enable the* to %rofit fro* tra'in& on thi! infor*ation. b. i. #echnical analysis in$ol$e! the !earch for rec#rrent an' %re'ictable %attern! in !toc" %rice! in or'er to enhance ret#rn!. The EMH i*%lie! that technical anal-!i! i! itho#t $al#e. If %a!t %rice! contain no #!ef#l infor*ation for %re'ictin& f#t#re %rice!) there i! no %oint in folloin& an- technical tra'in& r#le. ii. %!ndamental analysis #!e! earnin&! an' 'i$i'en' %ro!%ect! of the fir*) e.%ectation! of f#t#re intere!t rate!) an' ri!" e$al#ation of the fir* to 'eter*ine %ro%er !toc" %rice!. The EMH %re'ict! that *o!t f#n'a*ental anal-!i! i! 'oo*e' to fail#re. Accor'in& to !e*i!tron&/for* efficienc-) no in$e!tor can earn e.ce!! ret#rn! fro* tra'in& r#le! ba!e' on %#blicl- a$ailable infor*ation. Onl- anal-!t! ith #ni=#e in!i&ht achie$e !#%erior ret#rn!. In !#**ar-) the EMH hol'! that the *ar"et a%%ear! to a';#!t !o =#ic"l- to infor*ation abo#t both in'i$i'#al !toc"! an' the econo*- a! a hole that no techni=#e of !electin& a %ortfolio #!in& either technical or f#n'a*ental anal-!i! can con!i!tentl- o#t%erfor* a !trate&- of !i*%l- b#-in& an' hol'in& a 'i$er!ifie' %ortfolio of !ec#ritie!) !#ch a! tho!e co*%ri!in& the %o%#lar *ar"et in'e.e!. c. Portfolio *ana&er! ha$e !e$eral role! an' re!%on!ibilitie! e$en in %erfectl- efficient *ar"et!. The *o!t i*%ortant re!%on!ibilit- i! to i'entif- the ri!"?ret#rn ob;ecti$e! for a %ortfolio &i$en the in$e!tor,! con!traint!. In an efficient *ar"et) %ortfolio *ana&er! are re!%on!ible for tailorin& the %ortfolio to *eet the in$e!tor,! nee'!) rather than to beat the *ar"et) hich re=#ire! i'entif-in& the client,! ret#rn re=#ire*ent! an' ri!" tolerance. Rational %ortfolio *ana&e*ent al!o re=#ire! e.a*inin& the in$e!tor,! con!traint!) incl#'in& li=#i'it-) ti*e hori(on) la! an' re&#lation!) ta.e!) an' #ni=#e %reference! an' circ#*!tance! !#ch a! a&e an' e*%lo-*ent. 14. a. The earnin&! >an' 'i$i'en'@ &roth rate of &roth !toc"! *a- be con!i!tentl- o$ere!ti*ate' b- in$e!tor!. In$e!tor! *a- e.tra%olate recent &roth too far into the f#t#re an' thereb- 'on%la- the ine$itable !lo'on. At an- &i$en ti*e) &roth !toc"! are li"el- to re$ert to >loer@ *ean ret#rn! an' $al#e !toc"! are li"el- to re$ert to >hi&her@ *ean ret#rn!) often o$er an e.ten'e' f#t#re ti*e hori(on. b. In efficient *ar"et!) the c#rrent %rice! of !toc"! alrea'- reflect all "non rele$ant infor*ation. In thi! !it#ation) &roth !toc"! an' $al#e !toc"! %ro$i'e the !a*e ri!"/ a';#!te' e.%ecte' ret#rn. 11/A