We have seen that over long periods, stock investments
have tended to substantially outperform bond
investments, However, it is common to observe investors with long horizons holding entirely bonds. Are such investors irrational? No, stocks are riskier. Some investors are highly risk averse, and the extra possible return doesn't attract them relative to the extra risk. Explain why a characteristic of an efficent market is that investments in the market have zero NPVs. On average, the only return that is earned is the required returninvestors buy assets with returns in excess of the required return (positive NPV), bidding up the price and thus causing the return to fall to the required return (zero NPV); investors sell assets with returns less than the required return (negative NPV), driving the price lower and thus causing the return to rise to the required return (zero NPV). A stock market analyst is able to identify mispriced stocks by comparing the average price for the last 10 days to the average price for the last 60 days. If this is true, what do you know about the market? The market is not weak form efficient. If a market is semistrong form efficient, is it also weak form efficient? Explain. Yes, historical information is also public information; weak form efficiency is a subset of semi-strong form efficiency.
What are the implications of the efficient markets
hypothesis for investors who buy and sell stock in an attempt to "beat the market"? Ignoring trading costs, on average, such investors merely earn what the market offers; stock investments all have a zero NPV. If trading costs exist, then these investors lose by the amount of the costs. Rationality imagine all investors rational, when new information is released in the market place, all investors will adjust their estimates of stock prices in rational way. For example, while FCCs price $40, no one would now transact at that price. Anyone interested in selling would sell only at a price at least $45 (=$40 + 5). And anyone interested in buying would now be willing to pay up to $5. in other words, the price would rise by $5. Thus, perhaps it is too much to ask that all investors behave rationally, but the market will still be efficient if the following scenario holds. Independent Deviations from Rationality due to emotional resistance, investors could just as easily react to new information in a pessimistic manner. If investors were primarily this type, the stock price would likely rise less than market efficiency would predict. But suppose that about as many individuals were irrationally optimistic as were irrationally pessimistic. Prices would likely rise in a manner consistent with market efficiency, even though most investors would be classified as less than fully rational. Thus, market efficiency does not require rational individuals only countervailing irrationalities. Arbitrage Imagine a world with two types of individuals: the irrational amateurs and the rational professional. Arbitrage is the word generates profit from the simultaneous purchase and sale of different, but substitute, securities. If the arbitrage of professionals dominates the speculation of amateurs, markets would still be efficient.
What are stock market anomalies with the context of an
efficient market? Limits to arbitrage behavioral finance suggest that there are limits to arbitrage. That is, an investors buying the overpriced assets and selling the underpriced assets does not have a sure thing. Deviations from parity could actually increase in the short run, implying losses for the arbitrageur. Earnings surprises common sense suggest that prices should rise when earnings are reported to be higher than expected and prices should fall when the reverse occurs. However, market efficiency implies that prices will adjust immediately to the announcement, while behavioral finance would predict another pattern. Prices adjust slowly to the earning announcements, why do prices adjust slowly? Behavioral finance suggests that investors exhibit conservatism because they are slow to adjust to the information contained in the announcements. Size in 1981, two important papers presented evidence that in the US, the returns on stocks with small market capitalizations were greater than the returns on stock with large market capitalizations over most of the 20th century. Value versus growth a number of papers have argued that stocks with high book value to stock price ratios and/or high earnings to price ratios (generally called value stocks) outperform stocks with low ratios (growth stock). Value stocks have outperformed growth stocks in each of market researched, but further research is needed. Crashes and bubbles the stock market crash of October 19. 1987. The market dropped between 20% and 25% on Monday following a weekend. A drop magnitude for no apparent reasons is not consistent with market efficiency. Perhaps stock market crashes are evidence consistence with bubble theory of speculative markets. That is, security prices sometimes move wildly above their true values. Eventually, prices fall back to their original level, causing great losses for investors.
(Quantitative Perspectives On Behavioral Economics and Finance) James Ming Chen (Auth.) - Finance and The Behavioral Prospect - Risk, Exuberance, and Abnormal Markets-Palgrave Macmillan (2016)