Page 206 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 7: Efficient Market Theory

not follow its recommendations exactly, but they use it to evaluate basic risk and return Notes
trade-offs.
Why doesn’t everyone use the Markowitz model to solve his or her investment problems?
The answer again lies in the statistics. The historical mean return may be a poor estimate
of the future mean return. As you increase the number of securities, you increase the
number of correlations you must estimate – and you must estimate them correctly to
obtain the right answer. In fact, with more than 1,500 stocks on the NYSE, one is certain to
find correlations that are widely inaccurate. Unfortunately, the model does not deal well
with incorrect inputs. That is why it is best applied to allocation decisions across asset
classes, for which the number of correlations is low, and the summary statistics are well
estimated.

7.3 Benefits of an Efficient Market (Investors Utility)

So far, arbitrageurs sound like vultures waiting to swoop in for the kill. They take risks to
exploit new information at the expense of the less informed. The costs seem to be rewarding
opportunism at the expense of other investors. Are there any benefits to having a market
operate efficiently? Arguments in favour of efficient capital markets are: (1) The market price
will not stray too far from the true economic price if you allow arbitrageurs to exploit deviations.
This will avoid sudden, nasty crashes in the future. (2) An efficient market increases liquidity,
because people believe the price incorporates all public information, and thus they are less
concerned about paying way too much. If only the market for television sets were as efficient as
the market for stocks! A lot less comparison-shopping would be needed. (3) Arbitrageurs provide
liquidity to investors who need to sell or buy securities for purposes other than “betting” on
changes in expected returns.

Example: Currently, China is seeking to limit access to global financial information in
Shanghai (site of its major stock exchange). The government wishes to keep certain kinds of
information from market participants.
Market efficiency has implications for corporate managers as well as for investors. This takes a
lot of the “gamesmanship” out of corporate management. If a market is efficient, it is difficult to
fool the public for long and by very much. For instance, only genuine ‘news’ can move the stock
price. It is hard to pump-up the stock price by claims that are not verifiable by investors. ‘Fake’
news will not move the price at all. Even if it does so, the price will quickly revert to the pre-
announcement value when the news proves hollow. Publicly available information is probably
impounded in the price already. This is hard for some managers to believe. An example is Sears’
attempt to sell the Sears Tower in Chicago in the late 1980s. The company believed that, since it
carried the property on its balance sheet at greatly depreciated values, the public did not credit
the company with the full market price of the building and thus Sears’ stock was underpriced.
This proved to be false – in fact, it seems that Sears was overestimating the value of the building
and the stock price was relatively efficient! Another lesson: accounting tricks don’t fool anybody.
Don’t worry about timing accounting charges and don’t worry about whether information is
revealed in the footnotes or in the statements. An efficient market will quickly figure out the
meaning of the information, once it is made public.

7.4 Evidence for Market Efficiency

A simple test for Strong Form Efficiency is based upon price changes close to an event. Acts of
nature may move prices, but if private information release does not, then we know that the
information is already in the stock price.

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