MARKET EFFICIENCY
9 important questions on MARKET EFFICIENCY
What is an informationally efficient capital market, and which investment strategy is appropriate (active or passive)?
In an informationally efficient capital market, security prices reflect all available information fully, quickly, and rationally. The more efficient a market is, the quicker its reaction will be to new information. Only unexpected information should elicit a response from traders.
If the market is fully efficient, active investment strategies cannot earn positive risk- adjusted returns consistently, and investors should therefore use a passive strategy.
The intrinsic value or fundamental value
The intrinsic value or fundamental value of an asset is the value that a rational investor with full knowledge about the asset’s characteristics would willingly pay.
Implications of weak, semi-strong, and strong market efficiency for technical analysis, fundamental analysis, and active vs passive management.
- Technical: ❌ cannot earn abnormal returns
- Fundamental: ✔ may work
- Active vs Passive: active may add value
- Technical: ❌ no value
- Fundamental: ❌ no abnormal returns on average
- Active vs Passive: passive preferred
(Developed markets generally semi-strong.)
- Technical: ❌
- Fundamental: ❌
- Insider info: ❌
- Active vs Passive: passive only
(Real markets are not strong-form efficient.)
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Market anomaly due to data mining/snooping, definition
What time-series anomalies have been identified in market efficiency research? (three) (calendar, overreaction and momentum) and which violate which EMH
- January effect: In the first 5 days of January, stock returns—especially small firms—are significantly higher. Possible explanations: tax-loss selling in December and window dressing by portfolio managers. After risk adjustment, the effect does not persist.
Overreaction anomaly: Firms with poor past 3–5 year returns (“losers”) tend to outperform later, attributed to investor overreaction to good/bad news.
Momentum anomaly: Stocks with high short-term returns continue to generate high returns in the near term.
Both overreaction and momentum violate weak-form EMH because they rely only on past market data.
What cross-sectional anomalies have been identified in market efficiency research? (2) Size and Value effect and which form of EMH do they violate
Early studies found small-cap stocks outperform large-cap stocks.
Later research could not confirm this, suggesting the effect was either traded away (arbitraged out) or was simply a random, sample-specific result.
Value effect:
Value stocks (low P/E, low M/B, high dividend yield) have historically outperformed growth stocks (high P/E, high M/B, low dividends).
This violates semi-strong EMH because the information used to classify value vs. growth is publicly available.
Some researchers argue the value effect may reflect higher risk in value stocks rather than a true anomaly.
What is behavioral finance, and why is it relevant to market anomalies?
It shows that people often act with biases, follow others, avoid losses irrationally, and don’t judge risk the way traditional finance assumes.
These behaviors can explain why prices sometimes deviate from intrinsic value, creating the appearance of anomalies.
Give the three definitions of loss aversion, overconfidence and herding and why are they evidence for irrational behavior?
Investors hate losses more than they enjoy equal gains, so they may avoid selling losing positions or take excessive risks to avoid realizing losses.
Overconfidence:
Investors overestimate how good they are at analyzing stocks or spotting mispricing, leading them to trade too much or take unwarranted risks.
Herding:
Instead of doing their own analysis, investors copy what others are doing, all buying or selling in the same direction, which can amplify mispricing.
These behaviors show investors often act emotionally instead of rationally, which helps explain some market anomalies.
What is an information cascade, and how does it relate to market efficiency?
If the early movers are knowledgeable, others mimicking them can actually help prices move closer to intrinsic value, improving efficiency. But if people copy blindly, cascades can also spread irrational behavior.
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