Emh

[Avviey]

Hi,

I have afew questions to ask:

1)On page5 of Chapter 1, it says,'If insider trading doesnt occur, then the strong form EMH can not hold, as there is then no mechanism by which security prices can incorporate inside information.'

This makes sense as for strong form EMH, market prices incorporate all the information both publicly available and also that available only to insiders. However, what I dont understand here is if inside trading occurs, then it would be possible for the insiders to use this privileged information to obtain higher investment returns,then this shouldnt be strong form EMH?

2)On page 10 of Chapter 1 re the examples of over-reaction to events, no.1 is past porformance-market appears to over-react to past performance. Like making excess profits by selling firms that have performed well recently.Does this mean investors have over-reacted to the frims that have performed well recently but poor past performance by selling the firms? I'm not exactly clear here.

3)On page 11 of Chapter 1 re anomalies. The example of it is small companies effect. It says,'This work showed the out-performanceof small companies in the period 1960-80. However, if a stratgy based on this evidence had been implemented, the investor would have experienced abnormally low returns throughout the 1980s and early 1990s.' Shouldnt it be abnormally high returns given the out-performance? Probably I dont understand this bit.

Sorry for having asked a bunch. Would appreciate alot if someone can help.

 

[jensen]

Hi,

I have afew questions to ask:

1)On page5 of Chapter 1, it says,'If insider trading doesnt occur, then the strong form EMH can not hold, as there is then no mechanism by which security prices can incorporate inside information.'

This makes sense as for strong form EMH, market prices incorporate all the information both publicly available and also that available only to insiders. However, what I dont understand here is if inside trading occurs, then it would be possible for the insiders to use this privileged information to obtain higher investment returns,then this shouldnt be strong form EMH?

To me, i think of it as if the market is strong form EMH, then insider trading (whether it occurs or not) will not be useful at all because all prices already incorporate all info. If insider trading produces higher returns, then the market is not strong form EMH.

Hope this helps.

 

[Avviey]

Hmm, this makes sense. Thanks Jensen.

Any ideas of the 2nd and 3rd queries?

 

[jensen]

Hi Avviey

I dont have the notes, so I'll just try to comment from my head.

On Q2, I think it's just means that investors tend to over-react; they fear that firms that currently do well, will do badly in future.

On Q3, I dont remember this part of the notes. Perhaps you could elaborate bit more.

Cheers.

 

[Avviey]

Hi Jensen,

For Q2 below, it also says its possible to make excess profits by buy firms that have performed badly recently to illustrate that the market appears to over-react to past performance. Although I can vaguely see it, but I still dont get this concept, as this refers to past performance, but why whould investors buy firms that perform badly recently? Because they only concerned about the company's past perfromance? As the past performance was good, then investers would buy the firms to make excess profits regardless of the current bad performance and vice versa?

For Q3 below, note says,'Even more important is that the reported effects do not appear to persist over prolonged time periods and so may not represent exploitable opportunities opportunities to make excesss profits. For example, the small companies effect received attention in the early 1980s. This work showed the out-performance of small companies in the period 1960-80. However, if a strategy based on this evidence had been implemented, the investor would have experienced abnormally low returns throughout the 1980s and early 1990s. During this period no papers appeared claiming that small company returns disproved the EMH.' So I dont get this whole example to illustrate anomalies.

Thanks very much for your time.

Hi Avviey

I dont have the notes, so I'll just try to comment from my head.

On Q2, I think it's just means that investors tend to over-react; they fear that firms that currently do well, will do badly in future.

On Q3, I dont remember this part of the notes. Perhaps you could elaborate bit more.

Cheers.

 

[didster]

As with Jensen, I don't have the notes. But from the top of my head, I think your quotations are trying to say:

2) Some persons take the view that the market over-reacts to news (in particular bad news). If this were true, then the market would desperately want to sell stocks that performed badly, leading to a very cheap price. If you buy it AND the market corrects according to your view that it is underpriced, you would make profits.
Similarly you would want to sell stocks that have performed well in the past because you think the market has put too high a value on the stock and should fall soon enough to reach the "correct/true" value

This is essentially a contrarian approach (if you like big words) and as with all market strategies, it would only really work if your view of the market (in this case overreaction) is correct.

3) Perhaps you are missing the difference in the time periods. The small companies outperformed in the period 1960 to 1980 and underperformed (by the look of it) in the period 1980 to early 1990's, ie the following 15 years. It is just saying that the good performance in 1960 to 1980 was an anomaly, and strategies based on this would not have worked well as a result.

 

[Avviey]

Hi Didster,

Thanks alot for your time and explanation. I see what you mean for both Q2 and Q3.

Cheers.

 

[Anna Bishop]

Hi Avviey

Here's a tutor's view if it helps:

1. Insider trading

If there is no insider trading then the strong form EMH cannot hold.

If there is insider trading then:

- if people who do it can generate excess risk-adjusted returns over a prolonged period then this is evidence against strong form EMH

- if people who do it cannot generate excess risk-adjusted returns over a prolonged period then this is evidence in favour of strong form EMH.

2. Overreaction to past performance

A good example of this is the technology bubble in the late 1990s. People saw that stocks in technology companies were performing well and they wanted a slice of the cake. Lots of people continued to buy these stocks forcing up the price (arguably artificially as the fundamental prospects of these companies were not great). This was the overreaction! However, in March 2000, the bubble burst as investors realised that these weren't such sound investments after all, demonstrating much of the previous price rise was simply an overreaction to the past success.

By the way, on page 11, the third underreaction, I personally think this is actually an example of an overreaction!

3. Anomalies

I totally agree with Didster on this one. Small companies outperformed 1960 to 1980 and underperformed in the 1980s and 1990s. So an investor in 1980 who was thinking that small companies would continue to outperform would have been very disappointed!

This bit of the notes is trying to say that since the outperformance didn't persist, then we cannot use it as evidence against the semi-strong form EMH, ie it was just an anomaly.

All the best.
Anna

 

[Anna Bishop]

Hi Avviey

Here's a tutor's view if it helps:

1. Insider trading

If there is no insider trading then the strong form EMH cannot hold.

If there is insider trading then:

- if people who do it can generate excess risk-adjusted returns over a prolonged period then this is evidence against strong form EMH

- if people who do it cannot generate excess risk-adjusted returns over a prolonged period then this is evidence in favour of strong form EMH.

2. Overreaction to past performance

A good example of this is the technology bubble in the late 1990s. People saw that stocks in technology companies were performing well and they wanted a slice of the cake. Lots of people continued to buy these stocks forcing up the price (arguably artificially as the fundamental prospects of these companies were not great). This was the overreaction! However, in March 2000, the bubble burst as investors realised that these weren't such sound investments after all, demonstrating that much of the previous price rise was simply an overreaction to the past success.

By the way, on page 11, the third underreaction, I personally think this is actually an example of an overreaction!

3. Anomalies

I totally agree with Didster on this one. Small companies outperformed 1960 to 1980 and underperformed in the 1980s and 1990s. So an investor in 1980 who was thinking that small companies would continue to outperform would have been very disappointed!

This bit of the notes is trying to say that since the outperformance didn't persist, then we cannot use it as evidence against the semi-strong form EMH, ie it was just an anomaly.

All the best.
Anna

 

[Avviey]

Hi Anna,

Thanks very much for your time and further explanation.

For the 3rd under-reaction event on page 11, originally I thought it was under-reaction as the stock price slowly reacts as the market appears to over estimate the benefits from mergers. But once you mentioned, I think it did make sense if you interpret it as an example of over-reaction, as the market overrecated to the abnormal negative returns following mergers?