1
Q
How is the reversal effect evidence against the EMH?
A
- Contradicts semi-strong form of EMH.
- De Bondt & Thaler found portfolios of prior ‘losers’ outperform prior ‘winners’ in long-term based on past excess returns.
- Implies that extreme movements in stock prices followed by subsequent price movements in opposite direction (the more extreme initial price movement, greater the subsequent adjustment) –> contradicts theory of immediate price adjustment to all available info –> predictable patterns in price movements that can be exploited by investors to earn excess returns i.e. buying ‘losers’ & selling ‘winners’ –> in contrast to semi-strong form of EMH which states that excess returns can only be gained from taking on higher risk as explained by CAPM.
2
Q
How is the momentum effect evidence against the EMH?
A
- Contradicts semi-strong form of EMH.
- Jegadeesh & Titman found that stocks performing well in the past outperform stocks performing poorly in past in short-term based on past excess returns –> i.e. tendency of assets that have performed well in the past to continue performing well, & assets that have performed poorly to continue performing poorly, for a certain period –> contradicts theory of immediate price adjustment to all available info –> predictable patterns in price movements that can be exploited by investors to earn excess returns i.e. buying ‘winners’ & selling ‘losers’ –> in contrast to semi-strong form of EMH which states that excess returns can only be gained from taking on higher risk as explained by CAPM.
3
Q
How is the size effect evidence against the EMH?
A
- Contradicts semi-strong form of EMH.
- Banz (1981) found that small firms on average have significantly higher risk-adjusted returns than large firms.
- Firm size, which is publicly available information, helps to predict returns –> in contrast to semi-strong form of EMH which states that excess returns =0, & profits can only be generated by being fairly compensated for holding systematic risk in mkt as explained by CAPM.
4
Q
How is the value effect evidence against the EMH?
A
- Contradicts semi-strong form of EMH.
- Lakonishok et al. & Fama & French found that ‘expensive’/’growth’ firms w high mkt-to-book ratios earned sharply lower returns than ‘cheap’/’value’ firms w low mkt-to-book ratios.
- Firm value, which is publicly available information, helps to predict returns –> in contrast to semi-strong form EMH which states that all past relevant info re returns is already incorporated into stock prices & so mkt-to-book ratio cannot be used to predict future returns –> EMH also states excess returns =0, & profits can only be generated by being fairly compensated for holding systematic risk in mkt as explained by CAPM.
5
Q
How is post-earnings-announcement drift (PEAD) evidence against the EMH?
A
- Contradicts semi-strong form of EMH.
- Rendleman Jr et al. investigated PEAD –> stock prices of firms tend to drift in same direction as their earnings surprises following earnings announcements –> finds large proportion of PEAD adjustment course over 90-day period after earnings announcement.
- Some excess returns already exist before earnings announcement —> potential info leakage –> i.e. contradicting strong form of EMH.
- PEAD contradicts EMH by showing that prices do not react quickly to info –> after several weeks (even several months), there is still continued drift in prices –> factors other than systematic risk explain price drift so cannot be fully accounted for by CAPM.
6
Q
How is reaction to non-information evidence against the EMH?
A
- Contradicts semi-strong form of EMH.
- Shleifer & Wurgler & Zhuravskaya found that stocks newly included into the S&P 500 index have earned positive abnormal returns at annoucement of inclusion.
*Inclusion into Index unlikely to convey any info about firm, but generates substantial demand for firm’s shares via index funds so stock prices increase.
- Contradicts EMH by showing that prices react to non-info i.e. unrelated to intrinsic firm value but react to changes in demand.
7
Q
What is the joint hypothesis problem?
A
- Mkt efficiency tests are often joint tests of EMH & asset pricing model e.g. CAPM which measures abnormal returns after risk adjustment.
- Existence of anomalies could be attributed to lack of market efficiency or misspecification of pricing model or both.
8
Q
How does Neoclassical Finance explain EMH anomalies?
A
- By adding additional systematic risk factors to CAPM –> e.g. Fama-French three-factor model or Carhartt four-factor model.
9
Q
How does Behavioural Finance explain EMH anomalies?
A
- By relaxing investor rationality assumption –> e.g. heuristics, overconfidence in beliefs & prospect theory, ambiguity aversion in preferences.
10
Q
What are the 6 pieces of evidence against the EMH?
A
1) Reversal Effect –> De Bondt & Thaler.
2) Momentum Effect –> Jegadeesh & Titman.
3) Size Effect –> Banz.
4) Value Effect –> Lakonishok et al.; Fama & French.
5) PEAD –> Rendleman Jr et al.
6) Reaction to non-information –> Shleifer ; Wurgler & Zhuravskaya
