Chapter 9

Market Efficiency
and Behavioral
Finance

Market Price Behavior

Learning Goals
1. Describe the characteristics of an efficient
market, explain what market anomalies are, and
note some of the challenges that investors face
when markets are efficient.
2. Summarize the evidence which indicates that
the stock market is efficient.
3. List four decision traps that may lead investors
to make systematic errors in their investment
decisions.

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9-2

Market Price Behavior

Learning Goals (contd)
4. Explain how behavioral finance links market
anomalies to investors cognitive biases.
5. Describe some of the approaches to technical
analysis.
6. Compute and use technical trading rules for
individual stocks and the market as a whole.

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9-3

Random Walks and Efficient Markets

Random Walk: the theory that stock price
movements are unpredictable, so there is
no way to know where prices are headed
Studies of stock price movements indicate that
they do not move in neat patterns
This random pattern is a natural outcome of
markets that are highly efficient and respond
quickly to changes in material information

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9-4

Random Walks
and Efficient Markets (contd)
Efficient Market: a market in which securities
reflect all possible information quickly and
accurately
To have an efficient market, you must have:
Many knowledgeable investors actively analyzing and
trading stocks
Information is widely available to all investors
Events, such as labor strikes or accidents, tend to happen
randomly
Investors react quickly and accurately to new information

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Figure 9.1 Walmart Quarterly

Revenues

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Figure 9.2 Walmarts Stock Price

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Efficient Market Hypothesis

Efficient Market Hypothesis (EMH):

information is reflected in pricesnot only the type

and source of information, but also the quality and
speed with which it is reflected in prices. The more
information that is incorporated into prices, the
more efficient the market becomes.

Levels of the EMH

Weak Form EMH
Semi-strong Form EMH
Strong Form EMH

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Levels of EMH
Weak Form EMH
Past data on stock prices are of no use in predicting future
stock price changes
Everything is random
Should simply use a buy-and-hold strategy

Semi-strong Form EMH

Abnormally large profits cannot be consistently earned
using public information
Any price anomalies are quickly found out and the stock
market adjusts

Strong Form EMH

There is no information, public or private, that allows
investors to consistently earn abnormally high returns
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Figure 9.3 Daily Stock Price Reactions

Surrounding Positive Earnings News

Source: Andreas Neuhierl, Anna Scherbina, and Bernd Schlusche. Market Reaction to Corporate Press
Releases, forthcoming in the Journal of Financial and Quantitative Analysis.
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Market Anomalies
Calendar Effects
Stocks returns may be closely tied to the time of
year or time of week
Questionable if really provide opportunity
Examples: January effect, weekend effect

Small-Firm Effect
Size of a firm impacts stock returns
Small firms may offer higher returns than larger
firms, even after adjusting for risk

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Market Anomalies (contd)

Post Earnings Announcement Drift
(Momentum)
Stock price adjustments may continue after
earnings adjustments have been announced
Unusually good quarterly earnings reports may
signal buying opportunity

Value Effect
Uses P/E ratio to value stocks
Low P/E stocks may outperform high P/E stocks,
even after adjusting for risk
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Figure 9.4 Post Earnings

Announcement Drift

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Possible Explanations
Stocks that appear to earn abnormally
returns are actually riskier, so higher returns
merely represent compensation for risk
Some anomalies may simply be patterns in
that data that appeared by chance and are
thus not likely to persist over time
Behavioral biases may cause investors to
make systematic mistakes when they invest,
and those mistakes create inefficiencies in
the market
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Investor Behavior and Security

Prices
Overconfidence
Investors tend to be overconfident in their judgment,
leading them to underestimate risks

Self-Attribution Bias
Investors tend to take credit for successes and blame
others for failures
Investors will follow information that supports their beliefs
and disregard conflicting information

These biases may cause investors to trade too

often

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Investor Behavior
and Security Prices (contd)
Loss Aversion
Investors dislike losses much more than gains
Investors will hang on to losing stocks hoping
they will bounce back

Representativeness
Investors tend to draw strong conclusions from
small samples
Investors tend to underestimate the effects of
random chance

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Investor Behavior
and Security Prices (contd)
Narrow Framing
Investors tend to analyze a situation in isolation,
while ignoring the larger context

Belief Perseverance
Investors tend to ignore information that
conflicts with their existing beliefs

Familiarity Bias
Investors buy stocks that are familiar to them
without regard to whether the stocks are good
buys or not

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Behavioral Finance
at Work in the Markets
Stock Return Predictability
It maybe profitable to buy underperforming
stocks when they are out-of-favor
Momentum of stock prices up and down tends to
continue over 6- to 12-month time horizons
Value stocks may outperform growth stocks

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9-18

Behavioral Finance
at Work in the Markets (contd)
Investor Behavior
Investors who believe they have superior
information tend to trade more, but earn lower
returns
Investors tend to sell stocks that have risen in
value rather than declined
Investors acting on emotions instead of facts
may reduce market efficiency

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Behavioral Finance
at Work in the Markets (contd)
Analyst Behavior
Analysts may be biased by herding behavior,
where they tend to issue similar
recommendations for stocks
Analysts may be overly optimistic about a
favorite stocks future

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Using Behavioral Finance to Improve

Investment Results (Table 9.1)

Dont hesitate to sell a losing stock

Dont chase performance
Be humble and open-minded
Review the performance of your investment
on a periodic basis
Dont trade too much

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Technical Analysis
Before financial data/financial statements were
required to be disclosed, investors could only watch
the stock market itself to determine buy-or-sell
decisions
Investors began keeping charts of stock market
movements to look for patterns, or formations
that indicated whether to buy or sell
Studies have shown that anywhere from 20% to
50% of the price behavior of a stock can be traced
to overall market forces

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Technical Analysis (contd)

Technical Analysis is the study of the various
forces at work in the marketplace and their affect
on stock prices.
Focus is on trends in a business stock price and the
overall stock market
Stock prices are a function of supply and demand for
shares of stock
Used to get a general sense of where the stock market is
going in the next few months
Several technical indicators may be used together

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9-23

Market Technical Indicators

Confidence Index
Looks at ratio between yields on high-grade
corporate bonds compared to intermediategrade corporate bonds
Optimism and pessimism about the future
outlook is reflected in the bond yield spread
Trend of smart money is revealed in bond
market before it shows up in stock market

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9-24

Market Technical Indicators

(contd)
Market Volume
Pure supply and demand analysis for
common stocks
Strong market when volume goes up
Weak market when volume goes down

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9-25

Market Technical Indicators (contd)

Breadth of the Market
Looks at number of stock prices that go up
(advances) versus number of stock prices that
go down (declines)
Strong market when advances outnumber
declines
Weak market when declines outnumber
advances

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Market Technical Indicators (contd)

Short Interest
Looks at number of stocks that have been sold
short at any given time
Can give two different interpretations:
Measure of Future Demand for Stock
Strong market when short sales are high since
guarantees future stock sales to cover the short positions

Measure of Present Market Optimism or Pessimism

Weak market when short sales are high since professional
short sellers think stocks will decline

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Market Technical Indicators (contd)

Contrary Opinion and Odd-Lot Trading
Measures the volume of small traders
Assumes that small traders will do just the
opposite of what should be done
Panic and sell when market is low
Speculate and buy when market is high

Bull market when odd-lot sales significantly

outnumber odd-lot purchases
Bear market when odd-lot purchases
significantly outnumber odd-lot sales

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Figure 9.5 Basic Market Statistics

(Source: http://finance.yahoo.com/advances, accessed August 12, 2012.)

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Trading Rules and Measures

Advance-Decline Line
Measures the difference between stocks closing higher
and stocks closing lower than previous day
Difference is plotted on graph to view trends
Used as signal to buy or sell stocks
Bull market when advances outnumber declines
Bear market when declines outnumber advances

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Trading Rules and Measures (contd)

New HighsNew Lows
Measures the difference between stocks
reaching a 52-week high and stocks reaching a
52-week low
10-day moving average is plotted on graph to
view trends
Used as signal to buy or sell stocks
Bull market when highs outnumber lows
Bear market when lows outnumber highs

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Trading Rules and Measures (contd)

The Arms Index or Trading Index (TRIN)
Combines advance-decline line with trading volume
Used as signal to buy or sell stocks

Bull market when TRIN values are lower

Bear market when TRIN values are higher

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9-32

Trading Rules and Measures (contd)

Mutual Fund Cash Ratio (MFCR)
Tracks cash position of mutual funds
High cash positions in mutual funds provides
liquidity for future stocks purchases or
protection from future mutual fund withdrawals

Bull market when MFCR values are higher

Bear market when MFCR values are lower

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Trading Rules and Measures (contd)

On Balance Volume
Tracks the volume to price change relationship
as a running total
Up-volume occurs when stock closes higher and
is added to running total; down-volume occurs
when stock closes lower and is subtracted from
running total
Direction of indicator is more important than
actual value
Used to confirm price trends
Bull market when OBV values are higher
Bear market when OBV values are lower
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Using Technical Analysis

Charting
Shows visual summary of stock activity over
time
Easy to use and to understand
Use to spot developing trends

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Using Technical Analysis

Chart Formations
Looking for patterns, or formations, that
historically meant that stocks were going up or
down
Buy when stocks break through a line of
resistance
Sell when stocks break through a line of
support

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Figure 9.6 Some

Popular Chart
Formations

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Using Technical Analysis

(contd)
Moving Averages
Tracks data (usually stock price) as average
value over time
Used to smooth out daily fluctuations and
focus on underlying trends
Usually calculated over periods ranging from 10
to 200 days

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Figure 9.7 A 100-Day Moving

Average Line

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Chapter 9 Review
Learning Goals
1. Describe the characteristics of an efficient
market, explain what market anomalies are, and
note some of the challenges that investors face
when markets are efficient.
2. Summarize the evidence which suggests that
the stock market is efficient.
3. List four decision traps that may lead investors
to make systematic errors in their investment
decisions.

Copyright 2014 Pearson Education, Inc. All rights reserved.

9-40

Chapter 9 Review (contd)

Learning Goals (contd)
4. Explain how behavioral finance links market
anomalies to investors cognitive biases.
5. Describe some of the approaches to technical
analysis.
6. Compute and use technical trading rules for
individual stocks and the market as a whole.

Copyright 2014 Pearson Education, Inc. All rights reserved.

9-41

Chapter 9
Additional
Chapter Art

Table 9.1 Using Behavioral Finance to Improve

Investment Results

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9-43