Page 208 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 7: Efficient Market Theory

The assumption of semi-strong form efficiency is a good first approximation for a market with Notes
as many sharp traders and with as much publicly available information as the US equity market.

Is the Stock Market weak form Efficient?

Weak form efficiency should be the simplest type of efficiency to prove, and for a time it was
widely accepted that the US stock market was at least weak form efficient. Recall that weak form
efficiency only requires that you cannot make money using past price history of a stock (or
index) to make excess profits. Recall the intuition that, if people know the price will rise tomorrow,
then they will bid the price up today in order to capture the profit. Researchers have been testing
weak form efficiency using daily information since the 1950s and typically they have found
some daily price patterns, e.g. momentum. However, it appears difficult to exploit these short-
term patterns to make money. Interestingly, as you increase the horizon of the return, there
seems to be evidence of profits through trading. Buying stocks that went down over the last two
weeks and shorting those that went up appears to have been profitable. When you really increase
the horizons, stock returns look even more predictable. Eugene Fama and Ken French for
instance, found some evidence that 4-year returns tend to revert towards the mean. Unfortunately,
this is a difficult rule to trade on with any confidence, since the cycles are so long. In fact, they are
as long as the patterns conjectured by Charles Henry Dow some 100 years ago! Does this all lend
credence to the chartists, who look for cryptic patterns in security prices? Perhaps. But in all
likelihood there is no easy money in charting, either. Prices for widely traded securities are
pretty close to a random walk, and if they were not, then they would quickly become so, as
arbitrageurs moved in to buy the stock when it is underpriced and short it when it is overpriced.
But who knows? Maybe a retired rocket scientist playing around with fractal geometry and
artificial intelligence will hit upon something – of course if he or she did, it wouldn’t become
common knowledge, at least for a while.

Notes The efficient market theory is a good first approximation for characterizing how
prices in a liquid and free market react to the disclosure of information. In a word, ‘quickly!’
If they did not, then the market is lacking in the opportunism we have come to expect from
an economy with arbitrageurs constantly collecting, processing and trading upon
information about individual firms. The fact that information is impounded quickly in
stock prices and that windows of investment opportunity are fleeting is one of the best
arguments for keeping the markets free of excessive trading costs, and for removing the
penalties for honest speculation. Speculators keep market prices close to economic values,
and this is good, not bad.

Example: One of the most dangerous investment chestnuts is the idea that you can
successfully diversify your portfolio with a relatively small number of stocks, the magic number
usually being about 15. For example, Ben Graham, in The Intelligent Investor, suggests that
adequate diversification can be obtained with 10 to 30 names. In a classic piece in Journal of
Finance in 1968, Evans and Archer found that portfolios with as few as 10 securities had risk,
measured as standard deviation, virtually identical to that of the market. Over the decades, the
“15-stock diversification solution” has become enshrined in various texts and monographs,
most famously in A Random Walk Down Wall Street:
By the time the portfolio contains close to 20 equal-sized and well-diversified issues, the total
risk (standard deviation of returns) of the portfolio is reduced by 70 percent. Further increase in
the number of holdings does not produce any significant further risk reduction.

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