Page 218 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 7: Efficient Market Theory

7.7 Testing Market Efficiency Notes

There are several ways to test the EMH. Analysts have devised direct and indirect tests of market
efficiency. Direct tests assess the success of specific investment strategies or trading rules. An
example of a direct test would be a test of the accuracy of predictions by some specific technical
indicator. Indirect tests are statistical tests of prices or returns. For example, if prices follow a
random walk, the serial correlation of returns should be close to zero.
Establishing a Benchmark: Test of the EMH must usually establish some sort of benchmark. The
most common benchmark is the so-called buy-and-hold portfolio.
The Time Factor: The time period(s) selected can, of course, always be criticized. A trading rule
partisan may respond to a conclusion that the rule did not work by saying, “of course my
trading rule didn’t work over that period.”
Kiss and Tell: Suppose that someone discovered an investment strategy that really worked and
made a lot of money. Why would this person want to tell anyone? He or she could try to make
money writing a book or an investment newsletter describing the strategy, but it would probably
generate more money if keep secret. Suppose an analyst discovers that stocks beginning with
the letter K rise on Wednesdays and fall on Fridays.

Case Study Market Efficiency: Implications

conomist Dick Thaler In an August, FT opinion said quite nice things about "The
Myth of the Rational Market." In it, he makes the case that the efficient market
Ehypothesis consists of two main ideas, "No Free Lunch" and "The Price is Right,"
that have met very different fates over the past decade or so. After running through the
history, he concludes:

What lessons should we draw from this? On the free lunch component there are two. The
first is that many investments have risks that are more correlated than they appear. The
second is that high returns based on high leverage may be a mirage. ... On the price is
right, if we include the earlier bubble in Japanese real estate, we have now had three
enormous price distortions in recent memory. They led to misallocations of resources
measured in the trillions and, in the latest bubble, a global credit meltdown. If asset prices
could be relied upon to always be "right", then these bubbles would not occur. But they
have, so what are we to do?

While imperfect, financial markets are still the best way to allocate capital. Even so,
knowing that prices can be wrong suggests that governments could usefully adopt
automatic stabilising activity, such as linking the down-payment for mortgages to a
measure of real estate frothiness or ensuring that bank reserve requirements are set
dynamically according to market conditions. After all, the market price is not always
right.
Questions

1. Do you agree with Thaler's Ideas? Why/why not?
2. Do you think that financial markets are still the best way to allocate capital. Why/
why not?

Source: curiouscapitalist.blogs.time.com

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