TOPIC 4
SECURITIES AND TECHNICAL
ANALYSIS
B. Efficient Market Hypothesis
 For Topic 4BC
 Bodie [chapter 11]: The Efficient Market
Hypothesis; [chapter 12]: Behavioral Finance and
Technical Analysis
 Aronson [chapter 7]: Theories of Nonrandom
Price Motion
2
References Readings
The Efficient Market Hypothesis
(EMH)
 Existing information cannot be exploited to
realize above normal (risk-adjusted) trading
profits
 the current prices of securities reflect all
information about the security
 Weak form
 information = historical market information
 Semi-strong form
 Information = weak form + publicly available info
 Strong form
 Information= semi-strong form + private info
3
--> the complete information set
Dynamic Behavior of Prices
 In a frictionless environment, prices would follow
random walks
 Security price changes (returns) are not serially
correlated
 Equilibrium values exist and shares have
fundamental and unique values
 Informed investors form identical expectations
 Complex information translates into a single price
 Any analysis, including technical analysis would not
have any value
 But the real life is not as simple as elementary
economics 4
Support for Random Walk
 “Technical analysis is anathema to the academic
world. We love to pick on it. Our bullying tactics
are prompted by two considerations: (1) the
method is patently false; and (2) it's easy to pick
on."
 Burton Malkiel, A Random Walk Down Wall Street
 Stock price returns are very hard to predict
 Portfolio managers do not beat the market on
average and no one beats the market
consistently.
5
Opinion Against Random Walk
 “The efficient market hypothesis is the most
remarkable error in the history of economic
theory”
 Lawrence Summers, former U.S. Treasury Secretary
 Market bubbles and crashes.
 Market anomalies
6
Implications of Market Efficiency
 Pricing? Securities are selling at fair price
 Located on SML line (no mispricing)
 Timing the sale/purchase?
 Cannot time the market
 Pricing pressure effect?
 can sell many shares w/out affecting the price
 Cooking F/S?
 stock price does not react to accounting info
 Portfolio management?
 Passive strategy
 Role of portfolio manager?
 Yes, diversification, risk profile, tax
 Tailor the portfolio to meet the needs of the investor 7
Market Anomalies?
 Anomalies are empirical results that seem to be
inconsistent with maintained theories of asset-
pricing behaviour
 Small firms?
 Low P/E?
 High dividend yield?
 Earning momentum/surprise?
 Small sized firms?
 January effect?
 Institutional holdings?
8
What Motivates Individuals to Trade
 Informed traders
 Liquidity traders
 Noise traders
 One more – Divergent Expectations (people
disagree)
 Not homogenous expectations
 In practice, the very concept of uncertainty implies
that reasonable men may differ in their forecasts.”
 Evidence:
 Private information
 Analyst recommendations commonly differ
 Prevalence of short selling
 Two large investment funds trading with each other 9
TOPIC 4
SECURITIES AND TECHNICAL
ANALYSIS
C. Behavioral Finance
Gap Between Value and Price
 Traditional investment theories tell you that
there is an intrinsic value for the price of a
security based on its fundamentals.
 But the market price quoted in its bid and offer is
volatile and affected by volume and liquidity
(demand and supply factors) and sentiments
(psychology and emotion factors, fear and panic)
 Value and price is different and the market is
always wrong.
11
EMH and BF
 The EMH says that asset prices reflect all
available information and that investors are
rational economic agents, behaving in similar
ways and attempting to maximize expected
utility.
 The Behavioral Finance people suggest that
investors are not always rational. Traditional
theories ignore how people make complex
decisions with limited information and they may
be afflicted by cognitive and emotional biases
(greed and fear).
12
Psychology of Investment
 The science that investigates mental processes
and behavior
 Psychology plays a major role in investments
 People have information processing errors
 Investors do not have the assumed ability to process
correctly all the available information
 include forecasting errors (for e.g. infer incorrect
probability distributions about future rates of
return), overconfidence, conservatism, and sample
size representativeness
 Investors also suffer from behavioral biases
 They make inconsistent decisions
 such as framing, mental accounting, regret
avoidance, and prospect theory
13
Information Processing Biases
 Forecasting errors
 People give too much weight to recent experience
compared to prior beliefs when marking forecasting
and tend to make forecasts that are too extreme given
the uncertainty inherent in their information
 Overconfidence
 Investors tend to overestimate the precision of their
beliefs or forecasts and they tend to overestimate their
abilities
 Over-invest local companies or in shares of company
they work
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Information Processing Biases
 Conservatism and biased self-attribution
 Conservatism: Investors are too slow in updating their
beliefs in response to new evidence (creating momentum).
 Biased self-attribution: Overreact to public information that
confirms an investor’s private information; underreact to
public signals that disconfirm an investor’s private
information.
 Sample size neglect and representativeness
 People don’t consider sample size (representativeness issue)
 too quick to infer a pattern or trend from a small sample
 If all of your friends buying the same brand of shoes, it
doesn’t mean that that shoemaker would be a profitable
investment (consider the facts)
 Think it is more likely for a “tail” after a series of “heads”
15
Behavioral Biases
 Mental accounting
 proposes that people group their assets into a number of
mental accounts and segregate certain decisions
 take risks with their gains that they would not take with
their principal
 Regret avoidance
 Individuals tend to feel more regret when a more risky and
unconventional decision turns out badly.
 Focus on avoiding losses on stocks, unwilling to cut loss
 Framing
 Individuals’ decisions seem to be affected by how choices
are framed.
 The same problem is presented in two different ways and
investors give inconsistent choices
16
 Endowment Effect
 The tendency to consider something that you own to
have more worth than it would be if you did not own it.
 Ask yourself: you are holding a stock, would you still
buy this stock now or invest in something better?
 Anchoring
 Rely on first piece of information
 Associate a stock with its purchase price
 Unwilling to sell a stock at a price lower than your
purchase price
 When there is large unrealised gain, more willing to
sell the stock to capture the gains but less willing to
sell the stock when it has large unrealized losses
(disposition effect) 17
Behavioral Biases
Prospect Theory
 Proposed by Daniel Kahneman and Amos
Tversky
 People are more upset about losing $1000 than
are happy about gaining $1000
 risk-averse with regard to capturing gains.
 risk-seeking with regard to avoiding losses.
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Why Anomalies Exist?
 Behavioural finance
 Some believe that deviations in prices from intrinsic
value can be explained by behavioral psychology, in
two broad areas: cognitive processing biases and
behavioral biases
 Behavioral explanation of anomalies
 Attitudes toward risk - People generally dislike
incurring losses, yet they are more apt to take bigger
risks if they are experiencing a period of substantial
gains.
 Beliefs about probabilities - Individuals commonly
look back to what has happened in recent periods and
assume this is representative of future outcomes. 19