8 - Market Outcomes Flashcards
(10 cards)
What is the efficient market hypothesis (Fama, 1970)?
Prices of securities in financial markets fully reflect all available information in an efficient market. Inefficiencies will be small, short-lived and unpredictable.
What are some implications of EMH?
An average investor - whether an individual, a pension fund, or a mutual fund - cannot hope to consistently ‘beat the market’
Technical analysis, which relies on historical data to produce its forecasts, cannot successfully predict changes in stock prices. The vast resources that such investors dedicate to analysing, picking, and trading securities are wasted.
How does the traditional approach to market efficiency differ from the behavioural approach?
Traditional approach on market efficiency states that inefficiencies will be small, short-lived and unpredictable. However, psychological phenomena can cause departures from efficient pricing to be large and long-lasting.
Traditional approach: Assume all investors are rational.
Behavioural approach: Observe investor behaviours in stock selection (e.g., react to irrelevant information, pick up attention-grabbing stocks, etc.) and trading behaviours (e.g., trade frequently, disposition effect).
How can the size effect and market-to-book ratio effect be explained by representativeness?
Investors often favour large, high-growth firms thinking that they are representative of good investments. “If a company has high-quality management, a strong image and has enjoyed consistent growth in earnings, it must be a good investment…”
What is an argument to explain the winner-loser effect using representativeness?
Investors extrapolate into the future.
- Extreme winners = companies with several years’ good news become too expensive; subsequently earn negative abnormal returns
- Extreme losers = companies with several years’ poor news become too cheap; subsequently earn positive abnormal returns
How can the momentum effect be linked to disposition effect?
Good news –> Predispose investors tend to SELL the stock at a gain relative to the original purchase price. Winners selling retards the increase in price.
Bad news –> Predispose investors tend to HOLD the stock at a loss relative to the original purchase price. Losers holding slows down the price decrease.
Contributing towards momentum effect.
What are some behavioural explanations for the equity premium puzzle?
Ambiguity aversion - non-participation in stock markets arises from the rational decision by some traders to avoid ambiguity - may require ambiguity premium.
Loss aversion - the stock market needs to have a high average return, one that is significantly higher than on a safe asset, to ensure that the investor is willing to hold equity.
The aggregate stock market is negatively skewed: it is subject to occasional large crashes. These low probability events are over-weighted in people’s minds.
What is herding in financial markets?
The process where market participants contemporaneously trade in the same direction and/or their behaviour converges to the consensus.
Analysts may herd if influenced by other analysts.
Retail investors may infer information from the actions of other investors.
May be explained by anchoring and regret aversion. May be made worse by increased amount and frequency of information transfer/spread through social media.
According to the behavioural approach, why can arbitrage be much weaker and more limited than assumed in the traditional approach to market efficiency?
The key forces by which markets are supposed to attain efficiency, such as arbitrage, are likely to be much weaker and more limited due to various risks:
- Noise trader risk:
* Mispricing can become even worse before it gets better. So only arbitrageurs with deep pockets can afford the long-term horizon.
* Irrational investors may push prices further away from fundamentals, even after arbitrageurs take their positions
* Smart investors might temper their trades, and as a result the inefficiencies might be neither small nor temporary.
- Fundamental risk:
* Some stocks are more difficult to value (and thus arbitrage) than others. E.g., young, small, currently unprofitable, experiencing extreme growth, do not pay dividends for many years, has no earnings history, etc.
* Problematic for professional money managers betting on them
* Short-sell over-valued stocks when un-anticipated new (good) information suddenly arrive – price will rise, and a loss will be incurred
- Restrictions and transaction cost:
* Restrictions on short selling can limit arbitrage (some countries have limits on arbitrage).
* Nonavailability of the stock to short – less-liquid stocks
* The higher transaction costs of taking short positions in stocks, relative to long positions, dampens arbitrage activity.
What are some irrational beliefs that affect markets?
Excessive optimism and overconfidence cause the stock market to be overvalued. Speculative stocks are more sensitive to the changes in sentiment. When sentiment rises, investors may increase the riskiness of their portfolios by holding a higher proportion of stocks and by shifting into more speculative stocks.
Greater Fool Theory: You buy an asset that you realise is over-valued because you think there is a foolish individual out there who will pay even more – maybe you are unwise, but there is a “greater fool” somewhere.
