CHALLENGES TO MARKET EFFICIENCY

- ANJALI SINGH

• Rationality– People are not always rational.– Many investors fail to diversify, trade too much,

and seem to try to maximize taxes by selling winners and holding losers.

14.5 The Behavioral Challenge

• Independent Deviations from Rationality– Psychologists argue that people deviate from

rationality in predictable ways:• Representativeness: drawing conclusions from too little

data– This can lead to bubbles in security prices.

• Conservativism: people are too slow in adjusting their beliefs to new information.– Security prices seem to respond too slowly to earnings

surprises.

14.6 Empirical Challenges

Earnings Surprises: – Stock prices adjust slowly to earnings announcements.– Behavioral finance claim that investors exhibit

conservatism.

Size:– Small cap stocks seem to outperform large cap stocks.

Value versus Growth:– High book value-to-stock price stocks and high E/P ratio.

Crashes and Bubbles :

Bernard and Thomas, 1989Earnings Surprises

• Measure the abnormal risk-adjusted return after an earnings surprise.

• Earnings Surprise = Actual EPS – Forecasted Earnings

• If the stock market is efficient, any surprise when earnings are announced should be reflected rapidly in the stock price.

For positive earnings surprises:

• Larger earnings surprises lead to higher positive abnormal returns. • The upward drift in the stock price continues a couple of months

after the earning announcement.

For negative earnings surprises:

• Larger negative earnings surprises lead to larger losses as measured by the abnormal return.

• The downward drift in the stock price continues a couple of months after the earning announcement.

Loughran and Ritter, 1995

Graph shows the return of the portfolio of firms that have IPOs or SEOs.

The idea is that abnormal returns are negative( –),firms predictably underperform after equity issues.

Michaely, Thaler, Womack, 1995Graph shows the return of the portfolio of firms that initiate and that omit dividends.

The idea is that abnormal returns are positive for initiations and negative for omissions even after the event.

The Size Anomaly

• First explored by Banz (1981)

• Portfolios of small cap stocks earn positive abnormal risk-adjusted returns (+ alphas).

January Anomaly: Most of the abnormal returns of small firms occur in January

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Value vs. Growth (mid-large caps)

Value vs. Growth (small caps)