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Emh

The efficient market hypothesis (EMH) posits that share prices reflect all available information, suggesting that active portfolio management strategies may not consistently outperform passive strategies like index funds. Rational expectations theory indicates that individuals make decisions based on the best available information, while adaptive expectations rely on past data to form future expectations. Testing the EMH involves examining weak, semi-strong, and strong forms of market efficiency, with evidence generally supporting the weak and semi-strong forms, while the strong form is often violated.

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4 views

Emh

The efficient market hypothesis (EMH) posits that share prices reflect all available information, suggesting that active portfolio management strategies may not consistently outperform passive strategies like index funds. Rational expectations theory indicates that individuals make decisions based on the best available information, while adaptive expectations rely on past data to form future expectations. Testing the EMH involves examining weak, semi-strong, and strong forms of market efficiency, with evidence generally supporting the weak and semi-strong forms, while the strong form is often violated.

Uploaded by

mehnaz k
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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CHAPTER 2

EMH
INSTRUCTOR : Mehnaz Khan
The efficient market hypothesis (EMH)

The efficient market hypothesis (EMH) or theory states


that share prices reflect all information. The EMH hypothesizes
that stocks trade at their fair market value on exchanges.
Proponents of EMH posit that investors benefit from
investing in a low-cost, passive portfolio.

• This definition means that if an investor studies carefully the companies


that he/she invests in, it will not matter.
• There is no such thing, in this view, as a “cheap” stock or an “expensive”
stock.

• The current price is always the “best estimate” of the value of the
company
Active Portfolio Management
1.Objective: To outperform a specific benchmark index through various strategies.
2.Strategy: Active managers use research, forecasts, judgment, and experience to make investment
decisions.
3.Techniques: Frequent buying and selling of securities, market timing, and leveraging of investment
insights.
4.Cost: Higher fees due to more frequent trading and the need for extensive research and analysis.
5.Risk: Potentially higher risk due to the reliance on the manager's skill and market predictions.
6.Examples: Mutual funds managed by professional fund managers, hedge funds.

Passive Portfolio Management


7.Objective: To replicate the performance of a specific benchmark index, such as the S&P 500.
8.Strategy: Investments are made to mirror the holdings of the index, with minimal buying and selling.
9.Techniques: Buy-and-hold strategy, minimal changes to the portfolio.
10.Cost: Lower fees due to less frequent trading and reduced need for extensive research.
11.Risk: Generally lower risk as it aims to match the performance of the broader market, avoiding the
potential pitfalls of active management.
12.Examples: Index funds, exchange-traded funds (ETFs).
What are Rational Expectations?
Rational expectations is an economic theory that states
that individuals make decisions based on the best
available information in the market and learn from past
trends.
Rational expectations suggest that people will be wrong
sometimes, but that, on average, they will be correct.

In the 1950s and 1960s, economists regularly viewed expectations as formed from
past experience only. Expectations of inflation, for example, were typically viewed
as being an average of past inflation rates. This view of expectation formation,
called adaptive expectations, suggests that changes in expectations will occur
slowly over time as past data change

Even though a rational expectation equals the optimal forecast using all available
information, a prediction based on it may not always be perfectly accurate
Adaptive expectations
Adaptive expectations is a theory where individuals form their expectations of
future values of economic variables based on past values and past errors.
People adjust their expectations gradually in response to new information,
primarily relying on historical data.

Their expectations of inflation will almost surely be affected by their predictions of


future monetary policy as well as by current and past monetary policy. In addition,
people often change their expectations quickly in the light of new information.

To meet these objections to adaptive expectations, John Muth developed an


alternative theory of expectations, called rational expectations can be stated as
follows: Expectations will be identical to optimal forecasts (the best guess of the
future) using all available information.
Adaptive expectations

Key Features:

1.Past Experience: Expectations are formed by looking at past values of a


variable and adjusting them based on recent experience.

2.Adjustment Process: If the past expectation was incorrect, individuals adjust


their future expectations by a fraction of the past error.

3.Lagged Adjustment: There is often a time lag in the adjustment process,


meaning that individuals may not immediately incorporate all new information
into their expectations.
WEAK FORM TESTING :
the weak form is especially easy to subject to empirical testing, since there are
many money managers and market forecasters who explicitly rely on technical
research.
How do such managers and forecasters do? Do they perform as well as a
monkey randomly throwing darts at a newspaper containing stock price names
as a method of selecting a “monkey portfolio”?
Do index funds do better than money managers who utilize technical research
as their main method of picking stocks? These questions are simple to put to a
test and, over the years, the results of such testing have overwhelmingly
supported the weak form version of the EMH
•A money manager is a person or financial firm that manages the securities
portfolio of individual or institutional investors.
•Professional money managers do not receive commissions on transactions;
rather, they are paid based on a percentage of assets under management.
•A money manager has the fiduciary duty to choose and manage investment
in a way that puts clients' interests first, last, and always.
Questions to ask? (Answers of “NO”  WF market efficiency)
 are (future) returns predictable based on past returns and security
related info?
 can it (past returns and security related info) be used to make
abnormal trading profits?
How to test?
 time-series pattern of returns
 tests for return predictability
Empirical evidence?
 weak form efficiency (WFE) almost always holds (exceptions are
unheard of…)
Who believe that markets are not WF efficient and try to take advantage of
it?
 TECHNICAL ANALYSTS
• SEMI STRONG FORM TESTING:

• The semi-strong version of the EMH is not as easy to test as the weak
form, but data from money managers is helpful here.
• If the semi-strong version is true, then money managers, using public
information, should not beat the market, which means that they should
not beat simple indexes that mirror the overall market for stocks.
• The evidence here is consistent and overwhelming. Money managers, on
average, do not beat simple indexes. That doesn’t mean that there aren’t
money managers who seem to consistently outperform over small time
samples, but they are in the distinct minority and hard to identify before
the fact.
• Evidence from institutional investors, such as large pensions funds and
endowments, are consistent with the view that indexing tends to
produce better investment results than hiring money managers.
Questions to ask? (Answers of “NO”  SSF market efficiency)
 is there any delay or lack of accuracy in security prices reflecting new
publicly announced information?
 can abnormal trading profits be made based on publicly known info?
How to test?
 event studies: market reaction when an unexpected event (“surprise”)
takes place
 professional fund managers claim “outperforming” market based on
public info… Can they?
Empirical evidence?
 semi-strong form efficiency (SSFE) holds to a very large extent
 but well documented anomalies and exceptions occur
 most contentious aspect of market efficiency
Who believe that markets are not SSF efficient and try to take advantage of it?
 ACTIVE PORTFOLIO MANAGERS, HEDGE FUNDS, etc.
STRONG FORM TESTING

There is a third form of the EMH that is interesting but not easy to
subject to empirical validation. The third form is known as the strong
form of the EMH: Prices accurately summarize all information,
private as well as public
Questions to ask? (Answers of “NO”  SF market efficiency)
 can anyone with access to private (inside) information
successfully profit from it?
How to test?
 performance of insider-trading (e.g., Raj Rajaratnam,
founder/manager of hedge fund Galleon Group)
 performance of well-informed professional investors (like
Warren Buffet or George Soros)
Empirical evidence?
 strong form efficiency (SFE) never holds – is always violated
Who believe that markets are not SF efficient and try to take
advantage of it?
 Anyone with private information
We can identify three main lines of attack for critics of the semi-
strong form of the EMH:

1. Stock prices seem to be too volatile to be consistent with the


EMH.
2. Stock prices seem to have “predictability” patterns in historical
data.
3. There are unexplained (and perhaps unexplainable) behavioral
data items that have come to be known as “anomalies,” a
nomenclature begun by Richard Thaler.
Random Walk, the Martingale Hypothesis, and the EMH

There is an alternative, mathematical view of the stock market related to


the EMH. The mathematical version begins with the idea that stock prices
follow a process known as random walk. The idea of the random walk is
sometimes taken by wary observers as the idea that stock price behavior is
simply arbitrary, but that is not what random walk means.
• Imagine a coin flip where the coin is completely “fair” in the sense that a
heads or tails flip is equally likely to occur.

• Suppose you start with $100 in wealth before beginning a series of coin
flips. Suppose further that if you flip a heads, you receive $1, and if you
flip a tails, you have to give up $1.

• After the first flip, for example, you will have either $101 (if you flip a
heads) or $99 (if you flip a tails).Your total wealth over time, in this simple
example, is following a process known as a random walk.

• A random walk is a process where the next step (flip outcome, in this
example) has a fixed probability that is independent of all previous flips
Noise trader is a general
term used to
describe traders or
investors who make
decisions regarding buy
and sell trades in
securities markets
without the support of
professional advice or
advanced fundamental or
technical analysis.

Noise traders trade on


signals they believe to
generate better than
random returns, however
this belief is not well
founded. The idea of a

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