Fama's Research On Market Efficiency example essay topic

Webster defines "efficient" as acting or functioning competently, with minimum waste or extra motion. The term retains this meaning in the context of efficient markets. An efficient market must function competently, without waste or extra movement. What do we mean by functioning competently, however? One way to address this question is by looking at examples of markets that do not function efficiently. For example, most long distance interstate (from one state to another) phone rates are lower than long distance intrastate (within one state) rates.

While we know that this is due to competition and government regulation, it still defies what most people believe to be rational pricing. If these rates were set by the market instead of regulators, we would say that the market is functioning inefficiently. An efficient market also has prices adjusting rapidly and accurately. Before grocery stores used bar codes and computer networks to price inventory, each item had to have a price sticker attached. When an item's price changed, clerks had to put new price stickers on all of the items on the shelf. Time constraints sometimes restricted price changes to only adjusting prices on new inventory as it was tagged.

College students on tight budgets regularly searched items on the back of the shelf to see if any had old tags with lower prices still attached. This is another example of an inefficient market in that prices adjusted slowly, and not every unit of a particular type was priced the same. Now that we have explored a few examples of inefficient markets let us define what an efficient market is. In efficient markets all prices accurately and rapidly adjust to reflect the true intrinsic value of securities. Note several features about this definition. First, we say that prices are set accurately.

This precludes situations like interstate long distance rates being lower than intrastate rates. Second, the definition includes a time component. Prices must adjust quickly to changes in the environment. This precludes situations such as those we used to find in grocery stores. Consider what it means to investors if the financial markets are really efficient. If every stock is correctly priced then it makes absolutely no difference which stock you buy because every one is fairly priced.

It is a waste of time and energy to research the stock market because no amount of study will identify one security that will perform better than another. Does this mean you will be as well off buying Wal-Mart stock as Kmart stock? The surprising answer is YES. If the financial markets are efficient, the price of Kmart will have adjusted down to reflect the risk inherent in the company's future and the price of Wal-Mart will have adjusted up to reflect its expected future cash flows. "Bad" stocks will be cheap. "Good" stocks will be expensive.

Both will be priced fairly for what the investor gets. Students of finance are often disappointed to hear that the stock market may be efficient. They hope that by taking a course in finance they will learn some secret of how the markets function that will allow them to get fabulously wealthy by investing a little of their pocket change. This will not happen if the markets are efficient. Furthermore, if the markets are efficient there is no point in watching those investment gurus who provide stock advice on TV or reading The Wall Street Journal for investment tips. While it may be disappointing that in efficient markets no great deals exist, it also can be considered good news.

Put another way, if the markets are efficient, no matter what investment you choose, you will be getting a good deal. You can not make a stupid investment. You do not need to waste time searching for the right stocks; simply pick one that appeals to you for any reason and rest assured that you have selected a security that will provide a fair return for your investment. Of course, this is only true if the markets are really efficient. Before we look at the evidence supporting efficient markets, let us review why anyone would believe that the markets are truly efficient. 1.

What Makes the Markets Efficient? Suppose that you go into McDonalds this afternoon for lunch. As you enter, you note that the restaurant is busy and that there are four registers open. What are the chances that you will be able to walk directly up to the counter and place your order? Virtually none. The reason is that everyone there has the same goal, to get waited on as quickly as possible.

Customers, acting rationally in their own best interest, will seek out the shortest line. When you review your options, you will usually find that it does not make much difference which line you choose. They will all appear to provide about the same wait. Does this mean that it really makes no difference which line you choose?

Actually, they will not all move at the same speed. The guy in line two may be ordering lunch for a whole construction crew. Until you observe this order being placed, line two may have appeared to be a good option. Once this new information becomes available, you may choose to move to another line. The point is that when you initially picked a line, they all appeared to be equal given the information available to you at the time. Only the arrival of new information changes this.

Now suppose that line three unexpectedly shortens because two people in a row only order soft drinks. Now line three is a good deal. Anyone who gets in that line will have a shorter wait than if they get in any of the other lines. Who will get to take advantage of this good deal? The shorter wait will go to the customer who is alert to the opportunity and who moves most quickly to take advantage of it. The guy daydreaming at the end of line four never stands a chance.

Line three rapidly adjusted and the opportunity disappeared before he even knew a good deal existed. Let us review what makes the lines at McDonalds efficient. 1. Everyone has the same goal.

1. There are a large number of customers competing for good deals. 2. Some of the customers are alert to changes and new information.

3. Some of the customers react quickly to changes and new information. The security markets share these same characteristics. Everyone who participates in the financial markets has the same goal, to earn the greatest return possible for a given level of risk. Additionally, there are a large number of investors in the market. Currently, there are over 6,000 separate mutual funds, each with a manager searching for good deals for his clients.

In addition, there are millions of individual investors who actively participate in the security markets, again, each looking for good deals. It is hard to find an example of an asset with more prospective buyers than common stocks. Many investors and investment managers actively search for new information about the companies in which they invest. Larger investment funds have industry specialists who devote all of their time to studying one particular industry, such as steel, oil, or automobiles. They are constantly alert to any news reports which bear on the firms in their industry.

These specialists have access to news as soon as it is released through industry contacts and costly news sources. Some even have access to industry insiders who will help them analyze information as it is released. Finally, many participants in the security markets are willing and able to quickly react to new information. It is generally believed that most investors have little long-term firm loyalty. This means that they will not continue to hold a stock simply because they have had it for several years if another stock is available that is expected to provide a higher risk-adjusted yield. The efficient market hypothesis is based on the combined effect of many competitive investors, all with the same goal of locating securities that provide the highest risk-adjusted return and all willing and able to take advantage of new, changing conditions. A. Price Adjustments with the Security Market Line We can look to the security market line first introduced in Chapter 7 for another explanation for why we think the markets may be efficient.

Review Figure 9.1. Security A is providing a higher risk-adjusted return than other securities. Alert investors will identify this security and attempt to buy it. As demand pressure mounts for security A, its price will rise. Since the market price of the security will not affect its cash flows or dividends, a rising price will mean that the return will fall, the opposite of what we demonstrated with the GAP example above. The demand for security A will continue as long as its return is better than is available on other securities with similar risk.

Eventually, the price will rise until the return falls from R' to R. At this point, demand for the stock will dissipate and the price will stabilize. At its new price, security A provides a fair return to any investor who chooses to buy it. Investors who purchased it for less than its equilibrium price received a good deal in the form of excess returns. How many investors does it take to cause the price of security A to adjust to its proper level?

Only one, if that investor has sufficient wealth to buy the security until its price adjusts. With thousands of well-informed investors, all looking for any firm whose return deviates from the security market line, any deviation is expected to disappear very quickly. 1. Stocks Follow a Random Walk in Efficient Markets If the financial markets are indeed efficient, then past trends in stock prices should have no bearing on future price changes.

For example, just because a stock's price has had a series of price increases, as shown in Figure 9.2, we cannot assume that tomorrow's price will be at A. This is because everyone in the market has access to past stock prices. Suppose that if the stock price increases five days in a row there will be an increase on the sixth day as well. Investors would bid the price up on the fifth day instead of waiting for the sixth (the dotted line in Figure 9.2). As a result, the increase on the sixth day would disappear. In an efficient market, investors could not predict on day five whether the stock price on day six would be A, B, or C. If they could, an investment opportunity would exist that would provide superior returns.

The implication of Figure 9.2 is that the best prediction of tomorrow's price is today's price. For this reason the efficient market hypothesis is sometimes referred to as the random walk hypothesis. Suppose that you deposit a drunk friend in a field of corn. You give him a little shove and he staggers off.

If you leave and come back to search for him the next day, where would you begin your search? Where you left him. He probably will not be there, but in the absence of any additional information, that is the best place to start looking. In an efficient market, stocks will follow this same random walk.

The price will change from one day to the next, but you cannot predict the direction of consecutive movements. There is an old joke that has a financial academic walking down the street with a financial practitioner. They both spot a $1 bill lying on the sidewalk. The academic begins to walk past it, but is stopped by the practitioner who asks, "Aren't you going to pick that up?" The academic replies, "No, if it were really there someone else would have already taken it".

At this point the practitioner shrugs, picks up the dollar and walks on. While not an especially great joke, it points out that there are those who do not believe the markets are efficient and choose instead to pick up the dollars while the academic community debates the point. Are the markets really efficient, or is this theory, which sounds so rational when explained, simply wrong? Let us next review the evidence. 2. The Evidence For Market Efficiency A famous financial economist named Eugene Fama conducted the first major, comprehensive examination of the market efficiency question.

He recognized that there may be degrees of market efficiency ranging between a market that is not efficient to one that is perfectly efficient. To test just how efficient the market is, he looked first at whether the markets were even slightly efficient. He called this level of efficiency weak form market efficiency. If the markets were weak form efficient then all historical information would be reflected in stock prices. Put another way, no unusually high earnings would be possible by using historical information, such as past prices, old news articles, or last month's annual report. Fama deemed this the weakest test of market efficiency since historical information is readily available to everyone nearly costless ly.

If an investor could profit from using this type of information, the markets could not really be very efficient at all. After studying the results of dozens of research projects, Fama was unable to find any evidence that superior returns could be earned by using historical information. This rejected the entire field of technical analysis, which refers to investing based on studying the patterns of past prices. For example, a technical analyst may load a high speed computer with all of the stock returns for the last 60 years and program it to search for any patterns that repeat themselves. Say if two up-ticks followed by three down-ticks is usually followed by an up-tick, then a trading rule is established. The computer is then programmed to search current stock returns for the pattern and to issue a buy order whenever the pattern is located.

Even using the most sophisticated programs and most complicated data searches, Fama could uncover no convincing evidence of profits. He then proclaimed that the markets were at least weak form efficient. Fama next examined whether any public information could be used to earn superior returns. If no unusual profits could be earned using public information, the markets would be semi-strong form efficient. Fama reviewed studies looking at the impact of earnings announcements, stock splits, and other events for evidence that stock prices quickly adjusted to their news content.

He concluded that investors could not earn usual returns by trading on public information. This supported the idea that the markets are at least semi-strong form efficient. In a strong form efficient market all information, both public and private, is reflected in the price of the stock. In Fama's original research, he examined strong form market efficiency by looking at the performance of mutual funds. He hypothesized that mutual fund managers should have access to insiders who would provide them with inside, nonpublic information.

Many studies have been conducted attempting to show whether these managers are able to earn superior returns. To date, there is no convincing evidence that fund managers are able to outperform a random selection of stocks over the long run. A well-respected researcher named Michael Jensen looked at mutual fund performance. Jensen evaluated the risk and return of mutual funds and plotted them on the security market line. He found that more of them were below the line than above. This indicates that investing in a mutual fund results in about a 1% lower return than would be earned with a random pick of stocks.

Later in this same research paper Jensen demonstrated that the negative returns are approximately equal to the cost of staff salaries, office space, advertising, data acquisition, and commissions that mutual fund managers must pay. Thus, the source of the under performance is the expenditure of funds associated with the management of the funds. Most people do not consider this as supporting strong form market efficiency, since there is no proof that fund managers actually have insider information. Instead, the failure of fund managers to earn better returns than a random draw of stocks is viewed as additional support for semi-strong form efficiency. The Wall Street Journal has been running a contest for years where mutual fund managers are challenged to pick stocks that perform better than those selected by The Wall Street Journal staff who throw darts at the stock page of the Journal. So far the pros are ahead of the darts, but not by much.

For the market to be strong form efficient, no superior earnings would be possible, even with inside information. In fact there is a great deal of evidence that tremendous profits are possible when insider information is used. Despite insider trading being against the law and the severe penalties imposed for infractions, the profits frequently prove too tempting to pass up. In one of the most famous insider trading scandals, Ivan Bosky, a fund manager, conspired with Michael Milk in, an investment banker with Drexel Lambert Securities, to earn millions of dollars in insider trading profits. With this in mind we can safely reject strong form market efficiency. A. But What About Those Ads? If you read the financial press you will be inundated with ads explaining how one fund or another has outperformed the market for extended periods of time.

How is this possible if the markets are efficient and why does academic research show that fund managers do not outperform other investors? Suppose that you know nothing about football, but want to convince people that you do. One way would be to mail 10,000 letters to different people with half of them saying the Dallas Cowboys will win their next game and the other half saying the Cowboys will lose. Next week do the same thing, but only mail 5,000 letters to those who received the letter with the correct prediction the previous week. You will now have correctly predicted the outcome of two games to 2,500. Continue this process throughout the season.

After 10 games you will have correctly predicted the winner of every game to 20 people. You can now offer to tell them the winner of the eleventh game for a huge fee. There are thousands of investment fund managers. By pure chance, every year some emerge as beating the market and some are losers. Similarly, each successive year some will win and some will lose.

A few will emerge as winners over an extended period of time, again, all by pure chance. These winners will be hired by the big funds and will be promoted as financial experts with insights into the market that will yield extraordinary profits to those who trust them with their funds. For example, the Fidelity Magellan Fund has attracted $56 billion in investments due to its exemplary performance over a 13-year period. However, since 1990 it has had three managers who have failed to match its previous performance. Academic research tries to separate superior performance that is the result of truly exceptional ability from that due to chance. This is not an easy task.

For a fund to show statistical superiority it must outperform the market by a significant level over many years. With the difference between doing well and doing poorly being only a few percentage points, it is possible that our research has simply failed to identify a good performer as being a statistically significant good performer. This is the position taken by many practitioners on Wall Street. 3. The Evidence Against Market Efficiency, the Theory Shows a Few Cracks Through the 1960's, 1970's, and early 1980's, most research seemed to support the notion that the financial markets were at least semi-strong form efficient. Technical analysis was largely out of favor and investments grew in funds which simply mirrored some popular index such as the S&P 500 (these are called index funds).

Index funds were popular since they had lower fees made possible by not being actively managed. They generally provided returns at least as high as actively managed mutual funds. However, in the late 1980's a small body of research began emerging which identified situations where the market did not seem to be behaving efficiently. These situations were so rare that they were called anomalies and did little to shake anyone's faith in the concept of efficient markets or in the theories that relied on them. However, by the 1990's the evidence against market efficiency was becoming difficult to ignore. One of the first and most widely publicized anomalies was called the small firm effect.

Studies showed that small firms had outperformed large firms during most of the last 30 years. This performance advantage existed even when the returns were adjusted for the risk of small stocks as measured by beta. Various theories exist which suggest that the small firm effect is due to either portfolio rebalancing by institutional investors or to tax issues. Alternatively, it could be that there is some risk component of small firms that is not captured by beta and that justifies greater returns to those who hold small firms. In another blow to market efficiency research conducted by De bont and Thaler showed that the market may overreact to news announcements and that it may correct its errors slowly. This violates market efficiency, since a profitable trading rule can be devised to take advantage of the slow price adjustment of these stocks.

For example, whenever a firm announces that earnings have declined more than 40% below last year's level, wait until the stock price falls, then buy. The returns over the next few weeks should be greater than normal. It appears that the market is almost emotional in its overreaction to these surprise earnings announcements. An important study by Jedadeesh and Titman also suggests that the markets may not be as efficient as once thought.

They show that markets fail to recognize that good news has a tendency to follow more good news and that the same happens with bad news. When a firm announces earnings that are above expectations, the firm's stock goes up, as you might predict. However, it does not go up as far as it should. Subsequent good reports catch the market by surprise, and the price continues to climb. A rational, efficient market would be aware of this tendency. It would anticipate the good reports in advance and would not have to react upon their arrival.

Jedadeesh and Titman show that the market continues to be confused. When a firm makes several good reports the market seems to become convinced that these are the precursors of many more to follow. Unfortunately, winners tend not to remain winners and losers tend not to remain losers. Both tend to revert to the average.

Why does the market not learn this pattern and price stocks appropriately? Robert Haugen, a professor of finance and author of the book, The New Finance: The Case against Efficient Markets, says it is because the markets are not efficient at all. A. Is Beta Really Dead? Remember our discussion of Eugene Fama's research on market efficiency earlier in this chapter? He and Kenneth French wrote a paper that was voted the best article published in the Journal of Finance in 1992 by the widest margin in history.

Given that the Journal of Finance is the oldest and most prestigious journal in academic finance, this article may forever change traditional views about financial theory. Fama and French look at the returns accruing to value stocks and growth stocks. Value stocks are defined as those where the stock price is relatively low compared to earnings or to the accounting value of the firm's assets. These are firms that are somewhat out of favor in the market. Usually they have had low earnings and their low P / E ratio suggests that the market expects these low earnings to continue.

Growth stocks, on the other hand, have high P / E ratios and a high market-to-book ratio (low book-to-market ratio). These are the market favorites, for example, Microsoft and Wal-Mart. Fama and French sorted stocks into 10 groups each year by their book to market ratio and computed the annualized return. The results are shown in Figure 3. The out-of-favor value stocks have much higher earnings than the popular growth stocks!

Value stocks earned an average annualized return of 21.4% per year while the growth stocks earned only 8%. Keep in mind that each group contained over 200 stocks and that not all of those in the 1st group of value stocks performed well. On average, however, they significantly outperformed the growth stocks. While this is interesting research, so far it is not earth shaking.

The next contribution of the Fama and French paper was to plot beta against the book-to-market ratio. Remember that beta is the way risk is measured by the capital asset pricing model. In fact, according to CAPM, it is the only relevant measure of risk and should accurately predict returns. The higher the beta, the higher should be the returns.

Review Figure 4, which shows the relationship between beta and the book-to-market ratio. The popular growth stocks have high betas and the value stocks have low betas. In other words, the high-risk stocks, as measured by beta, have lower returns than the low risk stocks. The riskiest stocks can be expected to produce the lowest future returns and the safest stocks the highest.

These findings by such eminent financial economists shake the very foundation of market efficiency, the capital asset pricing model, and all that is based on it. David D reman, a regular columnist for Forbes and the manager of a large mutual fund, claims that Fama and French have caused the death of beta. Fama and French demonstrated that the book-to-market ratio can better predict stock returns than can beta. Proponents of market efficiency argue that this does not necessarily spell the death of either beta or of market efficiency.

Beta measures how much a company's stock price bounces around, compared with the market as a whole. Small firms and value companies are distressed. Their earnings may not be very volatile, but there is certainly the chance that something will go wrong. Investors may very properly demand additional compensation for incurring this risk in the form of higher returns.

The market may not be inefficient, we just may not yet have developed the tools needed to properly measure all of the risk of an investment. Future models may include other factors, in addition to beta, that measure firm risk. 4. So, Are Financial Markets Efficient or Not? We do not really know the answer to this question. On one hand, the reasoning behind the efficient market hypothesis is very appealing.

Consider that our whole capitalistic society is based on the idea that many rational people, all working in their own self interest, will provide the best mix of products at the best prices possible. Why should this not apply to financial markets, where the goals are clear and the competition is keen? If a security is priced too cheap, someone should recognize the error and take advantage of it to his own benefit. This activity should eventually correct the mis pricing.

On the other hand, we are continuing to identify situations where the markets fail the market efficiency test. We must determine whether it is market efficiency that fails or the tests that are poorly designed. Financial economists will be working on these questions for many years as they attempt to nail down the answer. What can we say about market efficiency today? First, sufficient research has been conducted in enough different arenas to establish that the markets function reasonably well. While we may question whether beta is the best measure of risk or whether small or troubled firms have some form of risk so far unidentified, we can continue making decisions assuming that security prices are fair and that it is very hard to outguess the market.

There are many stories about financial managers who believed that they could outsmart the market. Few succeed in the long run. For example, in 1994, Robert Citron lost $1.7 billion for the Orange County California investment fund by betting on interest rates. This put Orange County, one of the wealthiest counties in the country, into bankruptcy until 1996. Another example occurred in 1995, when many universities suffered losses in their endowment funds because they invested in the College Equities Fund. They used financial derivatives to gamble that they could outsmart the market.

Similarly, the Singapore manager of Lyons Bank in England gambled that he could beat the market. His losses also amounted to billions of dollars. Again, we see that even the professionals cannot outsmart the market. Let us next review the implications of market efficiency on financial decision making. 5. What Market Efficiency Means to Financial Decision Making If the financial markets are even reasonably efficient, most of the time most securities will be correctly priced.

What does this mean to the investor and to the financial manager? A. Do Not Try to Outsmart the Market If markets are efficient, security prices impound all available information about the value of each security. This means that to outsmart the market you not only have to know more than anyone else; you need to know more than everyone else. Only when you truly believe this to be true can you justify trading to beat the market. B. Do Not Waste Money or Time Looking for Good Deals Many investors spend great amounts of time and energy searching for good deals in the market. There was a graduate student in finance who saved for years to bring his family over from India so that he could get his Ph. D. from an American school. After studying finance for several years he believed that he could beat the market. He began trading daily.

He was constantly buying and selling stocks in an attempt to earn abnormal returns. How do you suppose this intelligent, well-informed investor did? After the first year of trading he had to send his family back to India to live with his parents. By the second year he had to leave, too.

What went wrong? If the market is efficient he should have just done as well as you would with a random pick of stocks, right? The problem was the transaction costs. Full service brokers charge about 3% to buy stocks, depending upon the cost of the stock and the size of the trade. Buying and then selling a stock costs about 6%. If this is done once per month, then you need to earn 12 ' 6% = 72% just to break even.

Clearly our friend could not do this. The moral of the story is that the current evidence on market efficiency suggests that the best investment strategy to follow will be one where you buy securities with the intention of holding them for long periods of time. Do not invest short term. Invest for the long term. This will minimize your transaction costs. C. Remember that History Does Not Matter If you flipped heads on a coin five times in a row, what is the probability that you will flip heads on the sixth attempt? The probability is still 50%.

This lesson is emotionally hard to follow sometimes, but the best evidence suggests it is true for the financial markets. Just because a stock has risen 10 days in a row, it will not necessarily continue to rise. In fact, the evidence suggests just the opposite. Many studies have shown that it is nearly impossible for analysts to accurately predict future growth more than a few quarters into the future. Yet the market tends to price stocks as if historical growth will continue unabated indefinitely. Buying stocks with very high price / earnings ratios has been shown to provide lower returns than buying value stocks, which have low price / earnings ratios.

6. A Final Note: What if the Markets Are not at all Efficient? There is a growing contingent of academics and practitioners who do not believe that the markets are efficient. T. Boone Pickens, a well known corporate raider, has made a fortune buying firms and subsequently selling them. He has scoffed at the idea of market efficiency for years, while earning vast sums doing what academics said was impossible.

Similarly, Robert Haugen, mentioned earlier in this chapter, has written a book which he feels refutes the market efficiency argument. While most people who have studied the evidence feel that the market is probably reasonably efficient, we might still ask, What if it is not? This would have a serious effect on many of our financial theories and decisions.