Page 219 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes 7.8 Are the Markets Efficient?

Today, it is fashionable to discuss the pending demise of the old EMH. Well, we are not quite yet
ready to bury it, but a considerable amount of evidence does contradict it, and more evidence
seems to emerge daily. However, a considerable amount of evidence also supports the concept
of market efficiency. And even if the markets are not efficient in an academic sense, they may be
efficient in a more practical sense. In most parts of the world, the financial markets are well
functioning, competitive institutions, in which consistent abnormal profits based on public or
historical information are rare.
There is an often-repeated joke about a trader and a finance professor walking down the street.
The trader notices a 500 note lying on the street and stops to pick it up. “Why bother?” the
finance professor says, “If it had really been a 500 note, someone would already have grabbed
it.”
In one sense, this joke sums up the debate over market efficiency. An unquestioning acceptance
of the EMH, and subsequent rejection of all investment analysis and research as worthless, can
leave a lot of money lying on the street for someone else.

7.9 Summary

An efficient capital market is one in which security prices adjust rapidly to the arrival of
new information and, therefore, the current prices of securities reflect all information
about the security.
Some of the most interesting and important academic research during the past 20 years
has analyzed whether our capital markets are efficient.
Fama divided the overall efficient market hypothesis (EMH) and the empirical tests of the
hypothesis into three sub-hypotheses depending on the information set involved: (1)
weak-form EMH, (2) semi-strong-form EMH, and (3) strong-form EMH.
In a subsequent review article, Fama again divided the empirical results into three groups
but shifted empirical results between the prior categories.
Therefore, the following discussion uses the original categories but organizes the
presentation of results using the new categories.

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.
An investor can add leverage to the portfolio by borrowing the risk-free asset.

The addition of the risk-free asset allows for a position in the region above the efficient
frontier.
Thus, by combining a risk-free asset with risky assets, it is possible to construct portfolios
whose risk-return profiles are superior to those on the efficient frontier.
A market portfolio is a portfolio consisting of a weighted sum of every asset in the
market, with weights in the proportions that they exist in the market (with the necessary
assumption that these assets are infinitely divisible).
Weak-Form and the Random Walk holds that present stock market prices reflect all known
information with respect to past stock prices, trends, and volumes.
Thus it is asserted, such past data cannot be used to predict future stock prices.

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