Define Behavioural Finance?
Studies how psychological biases affect financial decision-making –> prices deviate from fundamentals due to investors’ systematic mistakes.
Define Neoclassical Finance?
1) Assumes investor rationality.
2) Assumes prices accurately reflect fundamentals –> determined using DCF analysis –> prices only move if news about cashflows &/or discount rates.
3) Assumes efficient mkts.
4) Assumes Bayesian Updating –> i.e. new evidence already incorporated into investors’ expectations.
5) Assumes choices made according to EUT –> i.e. discount rate comes from some equilibrium models.
What is the Efficient Markets Hypothesis (EMH)?
Mkts are informationally efficient when security prices fully reflect all relevant info re fundamentals –> no investor can consistently, on average, generate excess/abnormal returns on known info.
What are the 3 (progressively weaker) conditions of market efficiency?
1) Investor rationality; investors do not make mistakes.
2) Investors can make mistakes –> but uncorrelated & cancel each other out.
3) Investors can make correlated mistakes, but rational investors (arbitrageurs) exploit errors & restore efficiency.
- If any of these 3 conditions met, mkt is efficient.
What is the definition of weak form efficiency?
Prices reflect all info contained in historical prices & returns.
What is the definition of semi-strong form efficiency?
Prices reflect all publicly available info (including past prices; past financial statements, press info etc.)
What is the definition of strong-form efficiency?
Prices reflect ANY info, public or private (e.g. insiders’ info).
What do EMH proponents argue about fundamental & technical analysis?
- Technical analysis based on historical data charts & fundamental analysis based on publicly available financial info will not successfully generate excess returns (i.e.. above expected, risk-adjusted return) –> as all relevant info regarding securities’ fundamentals already priced in.
Why is stale information not valuable in making profit in efficient markets?
Asset prices have already incorporated all current info so not affected by stale (outdated/irrelevant) info.
Do efficient markets rule out profits?
No - but profits must be fair mkt compensations for risk-bearing –> i.e. systematic profits associated w higher risk.
Why is active portfolio management not useful in efficient markets?
- On average no abnormal profits –> active trading involves holding non-systematic risk which is not compensated in eq by higher returns.
- If mkts are semi-strong efficient, then info already reflected in stock prices should include all info available to public so mutual fund managers should not consistently outperform mkt by picking undervalued/overvalued stocks.
-Passive investment strategies ‘tracking’ mkt recommended –> investor avoids holding individual stocks; should invest in index mutual funds or ETFs.
How is the EMH affected by the CAPM?
1) alpha = abnormal return over & above systematic risk –> idiosyncratic risk never compensated & hence should be diversified away as info specific to an individual asset is quickly incorporated into its price –> alpha = 0 on avg.
2) εi,t = actual excess returns –> will sometimes be above/below expected eq returns, i.e., may be +ve/-ve.
What are the 3 tests for an efficient market according to the EMH?
1) Security prices should not move in absence of news about its fundamental value –> i.e. should not react to changes in demand/supply not caused by news about fundamental value.
2) Security prices react to incorporate news about fundamental value quickly and correctly (do not under-react/overreact).
3) Abnormal return of strategies conditioning on known info should = 0.
What are the 3 pieces of empirical evidence supporting the EMH?
1) Random walk of prices (Fama, 1965)
2) Reaction to news (Fama et al., 1969; Keown and Pinkerton, 1981)
3) Ineffectiveness of active portfolio management (Jensen, 1968)
How is the random walk of prices evidence for the EMH?
- Supports weak form of EMH.
- Fama (1965) finds best guess for future price is current price, as past price movements provide no useful information for forecasting future price changes: Et(Pt+1) = Pt
- No systematic evidence that technical trading strategies, e.g. buying stocks when their prices increased or selling them when they went down, are profitable.
- Price of a stock on any given day is as likely to rise after a previous day’s increase as after a previous day’s decline.
How is reaction to news evidence of the EMH?
- Supports semi-strong form of EMH.
- Fama et al. (1969) conducts event study on stock split event –> company divides existing shares into multiple shares –> no predictable pattern of abnormal returns that can be exploited by investors in months after split, after increased dividends considered –> stock prices adjust rapidly to new info as mkt makes good forecasts of dividend implications of split, & relevant forecasts are fully incorporated into stock price by end of split month.
- Keown & Pinkerton (1981) supports semi-strong form –> examines daly stock price movements prior to public merger announcement –> prices quickly increase on day of public announcement info.
How is ineffectiveness of active portfolio management evidence of the EMH?
- Supports semi-strong form of EMH.
- Jensen (1968) examines whether active mutual funds exhibit stock picking skills over time for various funds –> finds on average active funds do not outperform mkt portfolio –> no single fund can consistently beat mkt –> all publicly available info quickly & accurately reflected in security prices, making it challenging for investors to consistently outperform mkt based on publicly available info.
