Market Efficiency versus Behavioral Finance

1. Discussion
§ Prof. Burton G. Malkiel → stock prices follow a random walk → cannot be systematically predicted by professionals
§ Markets are efficient → rationally and accurately reflect all publicly available information
§ EMH → Efficient Market Hypothesis
§ Very tight relationship between economic activity ↔ quantity of money
§ Market may get things wrong but 90% efficient
§ Advise from individual and institutional investors:
a. Buy and hold a broad-based, low-cost index fund
§ Index funds → active mutual funds underperforms a low-cost index mutual fund
§ Index funds → safer → lower cost than stocks → more stable

2. Are Stocks Prices Predictable? And Has EMH Survived the Bubble?
§ You can’t make and loose money in the market → you may lose transaction cost but you can’t lose money in the market
§ Campbell-Shiller → P/E multiples → P/E multiples above average → future market returns will be terrible
§ Malkiel → A buy and hold strategy, even without rebalancing, does better than Campbell-Shiller to move between bonds and stocks
§ Rebalancing → keep risk in control
§ When returns going to be high or low → not enough to do an investors any good → nobody can predict when the market will turn
§ Investors are part of the wind → they want to get out before the bubble pops
§ The worse get better ↔ the best get worse

3. How Does the EMH Account for Trading Volume?
§ If the market were efficient → people wouldn’t be doing all trading that they do → waste time and money
§ Trading is driven by rebalancing or liquidity needs
§ EMH → allow for variation:
a. Private information
b. Heterogeneity of opinion
§ Two reasons for excessive trading:
a. Overconfidence → Investors think they know something
b. Perverse incentives
§ Small investors consistently lose money
§ Invest in opposite of market not always profitable

4. Rationality and Arbitrage
§ Markets are sufficiently efficient → it’s not going to last very long
§ Strongest evidence that markets are very efficient is that you don’t see professionals making excess returns
§ We want to see pattern in the data → sometimes real pattern cannot be found → only appearance of the pattern
§ 10 % of the investors were rational → sufficient for market efficiency
§ Index fund is always fully invested → that’s the only way to track the index → index fund takes the full hit when the market is going down

5. Investor Choice and Public Policy
§ Indexing bonds is stronger than stocks because bonds are essentially a commodity product
§ Too much choices → investors confuse → wrong actions
§ There isn’t any persistence in performance

6. How do The Experts Invest Their Money?
§ Some people “play” in stock markets because it is fun
§ Some people really count the risk and the return