- The Different Types of Efficiency
• Weak Form
– Security prices reflect all historical information.
• Semistrong Form
– Security prices reflect all publicly available information.
• Strong Form
– Security prices reflect all information—public and private.
• Studies fall into three broad categories:
1. Are changes in stock prices random? Are there profitable “trading rules?”
2. Event studies: does the market quickly and accurately respond to new information?
3. The record of professionally managed investment firms.
• Financial Economists have sorted themselves into three camps:
1. Market efficiency
2. Behavioral finance
3. Those that admit that they do not know
• The EMH has three implications for corporate finance:
1. The price of a company’s stock cannot be affected by a change in accounting.
2. Financial managers cannot “time” issues of stocks and bonds using publicly available information.
3. A firm can sell as many shares of stocks or bonds as it desires without depressing prices.
The Behavioral Challenge
• Rationality
– People are not always rational.
– Many investors fail to diversify, trade too much, and seem to try to maximize taxes by selling winners and holding losers.
• Independent Deviations from Rationality
– Psychologists argue that people deviate from rationality in predictable ways:
• Representativeness: drawing conclusions from too little data
• This can lead to bubbles in security prices.
• Conservativism: people are too slow in adjusting their beliefs to new information.
• Security prices seem to respond too slowly to earnings surprises.
• Arbitrage
– Suppose that your superior, rational, analysis shows that company ABC is overpriced.
– Arbitrage would suggest that you should short the shares.
– After the rest of the investors come to their senses, you make money because you were smart enough to “sell high and buy low.”
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