Clarendon Lectures in Finance: The Adaptive Markets Hypothesis
The Inefficient Markets Hypothesis
Transcript of The Inefficient Markets Hypothesis
Behavioural Finance
Lecture 06Inefficient Markets Hypothesis
Recap
• Last Week– Market predominantly not random– But pattern of market movements very hard to work
out– Fractal markets hypothesis
• Market dynamics follow highly volatile patterns• “Fractal” dimensions to system with underlying
“deterministic” pattern plus noise• Measured by Box Dimension and Hurst Exponent
– Latter covered in addendum to lecture 5• This week
– If there are patterns to stock prices, what are they?• The “Inefficient Markets Hypothesis”
The impossibility of efficiency
• Key assumption of EMH– Investors can accurately predict the future
• “The first assumption is complete agreement…”– (“investors are assumed to agree on the
prospects of various investments”; Sharpe 1964)•And this distribution is the true one—that is, it
is the distribution from which the returns we use to test the model are drawn.” (Fama & French 2004)
• Reality—future uncertain– How do investors cope with
• Not knowing the future• And yet having to invest?
• Keynes: they form “conventions” about the future…
A Keynesian view
• Key issue is uncertainty, not risk– Cannot possibly estimate expected returns far into
future:• “our basis of knowledge for estimating the yield
ten years hence of [an investment] amounts to little...
• those who seriously attempt to make any such estimate are often so much in the minority that their behaviour does not govern the market.”
– Therefore investors can’t know “fundamental value”• Versus essential aspect of CAPM: investors can
work out “real value” of shares• Share values therefore always speculative
A Keynesian view
– Without knowledge of future, investors develop “conventions” to cope with uncertain future. They• “assume that the present is a ... serviceable
guide to the future…• that the existing state of ... prices ... is based on
a correct summing up of future prospects…; [and]
• we endeavor to fall back on the judgment of the rest of the world which is perhaps better informed.”
Keynes’s view
• Investors profit by picking shifts in confidence:– “the professional investor and speculator are ...
concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public… this behaviour... is an inevitable result of an investment market... For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence.” [OREF II]
• Markets thus conducted by speculation on immediate behaviour of other speculators, rather than rational calculation:
Keynes’s view
• The Stockmarket as a beauty contest and “the third degree”:– “… pick out the six prettiest faces … the prize being
awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole... We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.”
• The practicality of rational calculation?:– “Investment based on genuine long-term
expectation is … scarcely practicable. He who attempts it must surely … run greater risks than he who tries to guess better than the crowd how the crowd will behave…”
The “Price system” and Asset Markets
• Normal micro theory:– Supply a positive function of price– Demand a negative function of price– Supply and demand independent
• If price rises– Supply rises– Demand falls– Tendency towards equilibrium
• But finance markets– Supply (of assets, shares) possibly a positive
function of price– Demand also a positive function of price:
The “Price system” and Asset Markets
• If price of assets (shares, real estate, etc.) rising, demand also rises– Buyers hope to buy and sell on a rising market
• The faster the rate of price increase (generally speaking) the faster the growth of demand
• Tendency to move away from “equilibrium” (“fundamental value”, historic price to earnings ratios, etc.)
• Price thus destabilises an asset market• Far-from-equilibrium process means
– Overvaluation of popular “growth” stocks– Undervaluation of unpopular “value” stocks…
The “Inefficient Markets Hypothesis”
• Argument that investors– React slowly to news– Under-react and Over-react– Ignore “reversion to the mean”
• Series of good reports leads to expectation of more good news
• Firm valuation rises, seen as “growth stock”– rise becomes self-fulfilling; bandwaggon buying
• Firm cannot sustain above sector/economy performance indefinitely
• Initial “bad news” reports ignored as firm “reverts to mean”
• Finally, “bear” valuations set in; bandwaggon selling– “growth stock” underperforms in medium term
The “Inefficient Markets Hypothesis”
• 90% of price variability due to internal dynamics of speculators watching other speculators:– EMH idea of investors focusing solely upon
expected risk/return wrong:Instead,
speculators watch other speculators
The “Inefficient Markets Hypothesis”
• Key outcomes of “Inefficient Markets Hypothesis” (IEH)– Shares with low volatility outperform the market
• Opposite of EMH– Markets characterised by
• Slow reaction by investors to news• Under and over reaction at different times
– Institutional investors behave differently to individuals• Forced by short time horizon to match Index• Advantage for individuals over institutions
– Best stocks to buy are ones doing poorly now• Likely to have better growth and lower
downside volatility in future
The “Inefficient Markets Hypothesis”
• Companies with good results now– Tend to become complacent– Attract competitors– Get high stock market valuations
• Companies with poor results now– Face “improve or die” pressure– If in “dull” industries, don’t face many competitors– Get low stock market valuations
• Inversion of future performance results– “Good” results now often followed by poor ones– “Poor” results now often followed by good ones
• “Reversion to the mean”
The “Inefficient Markets Hypothesis”
• “Contrarian strategy” of buying poor performers now– Won’t work in short-medium term
• Market over-valuation of “good” companies will give them good short-medium term results
– Will work in medium-long term• Persistent failure of “good” companies to
maintain results slows share price rise• “Unexpected” good performance of “poor”
companies– Yields good dividends– Leads to eventual market revaluation of
shares• So non-institutional investors can “outperform the
Index” by value & contrarian investment– But…
The “Inefficient Markets Hypothesis”
• Individual investors don’t necessarily do this– Self-defeating (“irrational”?) behaviour as well…
• “follow the advice of financial gurus,• Fail to diversify,• Actively trade stocks and churn their portfolios,• Sell winning stocks and hold on to losing stocks
thereby increasing their tax liabilities…” (Shleifer 2000 p. 10)
– Undermines both EMH and possible gains from market inefficiency
• Also partly explains market inefficiency• As does behaviour of money managers…
The “Inefficient Markets Hypothesis”
• Professional managers:– “choose portfolios that are excessively close to the
benchmark they are evaluated against …• To minimise the risk of underperforming this
benchmark…– Herd and select stocks that other managers select,
• Again to avoid falling behind and looking bad…– Add … stocks that have recently done well, and– Sell stocks that have recently done poorly,
• To look good to investors who are getting end of year reports on portfolio holdings…” (Shleifer 2000 pp. 12-13)
The “Inefficient Markets Hypothesis”
• “Bottom line” of IEM– Two major groups of investors
• Fund Managers– Short-term horizon forces index following
• Individuals– Behavioural herding causes following of fads
– Market inefficiency generates opportunities• Fund managers can’t pursue because of short-term
monitoring• Individuals tend to miss by “following the crowd”
– Opportunities to profit from “contrarian” investing• Buy high B/M, out of favour sectors, low volatility• Worse performance over short term possible• Better performance over medium-long term likely
Haugen’s Research
• Main proponent of IEM is Robert (Bob) Haugen– Academic till mid-90s– Resigned to apply ideas for profit– Published several books between academic &
commercial career• The Inefficient Stock Market• The Beast on Wall Street• The New Finance
• All detail– Empirical failings of CAPM– Ways to profit from market systematic mispricing– All are “contrarian” strategies:
• Buy “out of favour” stocks & profit
Haugen’s Research
• Famous book “In Search of Excellence” studied companies regarded as excellent in terms of 6 characteristics as of 1980: Asset Growth; Equity Growth; Market to Book Ratio (favouring high over low); Return on Capital, Equity, & Sales– Ranked companies from “Excellent” to
“Unexcellent” on weighted scale of these factors• Clayman (1987) checked subsequent performance of
two groups• Both excellent and unexcellent reverted to mean…
– Better results from investing in “unexcellent” companies than “excellent” ones:
"Excellent" versus "Unexcellent" Companies (76-80)
• Excellent companies looked much better than unexcellent ones:
8.628.62
19.0519.05
16.0416.04
2.462.46
18.4318.43
21.7821.78
2.492.49
7.097.09
4.884.88
0.620.62
3.763.76
5.935.93
00
22
44
66
88
1010
1212
1414
1616
1818
2020
2222
2424
Asset Asset GrowthGrowth
Equity Equity GrowthGrowth
Market-Market-Book RatioBook Ratio
Return on Return on Total CapitalTotal Capital
Return onReturn onEquityEquity
Return Return on Saleson Sales
"Excellent Companies""Excellent Companies" "Unexcellent Companies""Unexcellent Companies"
"Excellent" versus "Unexcellent" Companies (81-86)
• Results opposite of what fans of excellent companies expected:
8080
130130
180180
230230
280280
19811981 19821982 19831983 19841984 19851985 19861986
UnexcellentUnexcellentCompaniesCompanies
ExcellentExcellentCompaniesCompanies
297.5297.5
181.6181.6
Source: M. Clayman, 1987, Financial Analysts Journal, “In Search of Excellence:The Investor’s Viewpoint.”
Cumulative Value of $100 Invested in 1981Cumulative Value of $100 Invested in 1981
"Excellent" versus "Unexcellent" Companies (81-86)
• Clayman’s conclusion:– “Over time, company results have a tendency to
regress to the mean• As underlying economic forces attract new
entrants• And encourage participants to leave low-return
businesses.– Because of this tendency
• Companies that have been “good” performers in the past may prove inferior investments
• While “poor” companies frequently provide superior investment returns in the future.” (1987, p. 63)
• Many other similar patterns uncovered by Haugen…
Haugen’s Research
• Future Returns to Stocks– Cheap Stocks vs Expensive
• Relative to Current Earnings and Dividends– Stocks ranked and re-ranked
• by earnings• and dividend yield as of April of each
year.– Subsequent performance of cheapest and
most expensive quartiles then monitored.
Haugen’s Research
• Cumulative Value of $1 Invested in Various Forms of Value and Growth
00
1010
2020
19
68
19
68
19
70
19
70
19
72
19
72
19
74
19
74
19
76
19
76
19
78
19
78
19
80
19
80
19
82
19
82
19
84
19
84
19
86
19
86
19
88
19
88
19
90
19
90
19
92
19
92
19
94
19
94
19
96
19
96
YearYear
Cum
ula
tive V
alu
e o
f $
1 Invest
ed
Cum
ula
tive V
alu
e o
f $
1 Invest
ed
3030
4040
5050
6060
7070
8080
9090
100100
High YieldHigh YieldLow YieldLow Yield High P.E.High P.E.Low P.E.Low P.E.S&P 500S&P 500
High dividend yield and low High dividend yield and low price to earnings ratio shares do price to earnings ratio shares do
betterbetter
Haugen’s Research
• Relative Performance of Portfolios Equally-weighted in the Cheap and Expensive Quartiles
• Difference in cumulative return is measured over rolling 5-year periods. – Relative performance appears to cycle over time.– But cheap stocks out-perform more often than not
• In following graphs, “efficient” means “what works”– CAPM idea of “efficient portfolio”
• Efficient means risk-return tradeoff– Higher return necessitates higher v
– Actual investing experience• Efficient means lower volatility and higher
return
Haugen’s Research
• The Effect of Moving to Lower and Higher Risk Portfolios of NYSE Stocks - 1928-1992
S&P 500S&P 500
Inefficient PortfolioInefficient Portfolio
Efficient PortfolioEfficient Portfolio
16%16% 18%18% 20%20% 22%22% 24%24% 26%26% 28%28% 30%30%
RiskRisk
6%6%
7%7%
8%8%
9%9%
10%10%
11%11%
12%12%
Realize
d A
nn
ual R
etu
rnR
ealize
d A
nn
ual R
etu
rn
Haugen’s Research
• The Effect of Moving to Lower and Higher Risk Portfolios (1979-1992)
Inefficient VersionInefficient Version
EfficientEfficient VersionVersion
Efficient VersionEfficient Version
Inefficient VersionInefficient Version
Small Firm Stock IndexSmall Firm Stock Index
10%10%12%12% 14%14% 16%16% 18%18% 20%20% 22%22% 24%24% 26%26% 28%28%
RiskRisk
12%12%
14%14%
16%16%
18%18%
20%20%
Realize
d A
nn
ual R
etu
rnR
ealize
d A
nn
ual R
etu
rn
Large FirmLarge Firm Stock IndexStock Index
Haugen’s Research
• The Effect of Moving to Lower and Higher Risk Portfolios of Large and Small Value Stocks (1979-1992)
Inefficient VersionInefficient Version
Efficient VersionEfficient Version
Small Value Small Value Stock IndexStock Index
Inefficient Inefficient VersionVersion
Efficient Efficient VersionVersion
Large ValueLarge Value Stock IndexStock Index
12%12% 14%14% 16%16% 18%18% 20%20% 22%22% 24%24% 26%26% 28%28%
RiskRisk
14%14%
15%15%
16%16%
17%17%
18%18%
19%19%
20%20%
Realize
d A
nn
ual R
etu
rnR
ealize
d A
nn
ual R
etu
rn
Haugen’s Research
• Effect of Moving to Lower and Higher Risk Portfolios of Large and Small Growth Stocks (1979-1992)
14%14% 16%16% 18%18% 20%20% 22%22% 24%24% 26%26% 28%28% 30%30%
RiskRisk
14%14%
15%15%
16%16%
17%17%
18%18%
Realize
d A
nn
ual R
etu
rnR
ealize
d A
nn
ual R
etu
rn
10%10%
11%11%
12%12%
13%13%
9%9%
8%8%
Inefficient Inefficient VersionVersion
Efficient VersionEfficient Version
Small Growth Stock Small Growth Stock IndexIndex Inefficient Inefficient
VersionVersion
Efficient Efficient VersionVersion
Large GrowthLarge Growth Stock IndexStock Index
Haugen’s Research
• The Relative Performance of Low- and High-volatility Stock Portfolios– What has been the performance– Over overlapping 5-year periods
• Of low- and high-volatility portfolios relative to the S&P 500 (positioned at the origin of the graph)?
– Risk-return tradeoff idea of CAPM implies• Higher volatility portfolio would have higher
return• Lower volatility, lower return• Data should “tilt up” in scatter plot
– But instead…
Haugen’s Research
• Test of 5 Year Horizon Performance of Low and High Volatility Portfolios using S&P 500 Stocks (1972-1992)
-10%-10%
-8%-8%
-6%-6%
-4%-4%
-2%-2%
0%0%
2%2%
4%4%
6%6%
8%8%
10%10%
Volatility Relative to S&P 500Volatility Relative to S&P 500
-10%-10% -8%-8% -6%-6% -4%-4% -2%-2% 0%0% 2%2% 4%4% 6%6% 8%8% 10%10%
Retu
rn R
ela
tive to
S
&P
5
00
Retu
rn R
ela
tive to
S
&P
5
00
Low Volatility PortfolioLow Volatility Portfolio
High Volatility PortfolioHigh Volatility PortfolioData tilts down: lower volatility, higher return!
Data tilts down: lower volatility, higher return!
Haugen’s Research
• Over-estimation of Short-run– Relationship Between Perceived and True Growth
Horizon and Average Growth Rates• Growth horizon: length of time a typical stock
takes to mean-revert to the average rate of earnings growth.
– Perceived horizon is longer than the true horizon
• Reversion to the mean cuts in ahead of expectations
• “Growth” stocks– Perform well in short term– Disappoint in medium term
Haugen’s Research
• Over-estimation of Short-run
AboveAboveAverageAverage
AverageAverage
BelowBelowAverageAverage
True Growth True Growth HorizonHorizon
Perceived Growth Perceived Growth HorizonHorizon
Relative GrowthRelative Growth
Years into FutureYears into Future
• Investors expect high Investors expect high performers will remain performers will remain “ahead of the pack” “ahead of the pack” for much longer than for much longer than they dothey do
• Overprice growth Overprice growth stocks in interimstocks in interim
• Reduce price in Reduce price in medium term as medium term as reversion to mean reversion to mean kicks inkicks in
Haugen’s Research
• Relationship Between Perceived and True Growth Horizon and Average Growth Rates– Investors over-estimate
• average rate of growth• And length of the growth horizon
Haugen’s Research
• Overestimation of Short Run and Average Growth
AboveAboveAverageAverage
PerceivedPerceivedAverageAverage
BelowBelowAverageAverage
True Growth True Growth HorizonHorizon
Years into FutureYears into FutureTrue AverageTrue Average
Perceived Growth Perceived Growth HorizonHorizon
• InvestorsInvestors– expect current growth expect current growth
will be higher and last will be higher and last longer than proves to longer than proves to be the case…be the case…
– Over-estimate Over-estimate average industry average industry growth as wellgrowth as well
Haugen’s Research
• Tendencies identified in IMH– Explain “fractal” nature of stock market data
• Initial under-reaction to good news• Then over-reaction to good news• Followed by disappointment by mean reversion• Volatile “up-down” feedback
– Give non-institutional investor opportunity to profit• Analyse stocks to identify
– Low volatility– High Book to Market– Out of favour sectors etc.
• Develop portfolio of such stocks• Adjust on quarterly basis (minimise transaction
costs)
Haugen’s Research
• An instance: exploit under-pricing of high Book to Market stocks– Data from French (of Fama & French—once
proponent of EMH):• http://mba.tuck.dartmouth.edu/pages/faculty/ke
n.french/data_library.html– Rank companies by Book to Market Value
• Negative (negative book value—like Internet startups 1996-2000)
• Low 30% (“Growth stocks”—expensive but expected to grow above trend by market
• Medium 40%• High 30% (“Value stocks”—Buffett-style buy)
Haugen’s Research
• $1 invested in 1926 in portfolio is worth in 2009:– Negative B/M: $16– Low 30%: $1,074– Medium 40%: $2,415– High 30%: $14,507
1920 1930 1940 1950 1960 1970 1980 1990 2000 20100.01
0.1
1
10
100
1000
10000
100000
Negative Book ValueLow 30%Medium 40%High 30%
Portfolio Performance by Book to Market Valuation Ratio
Years
Cum
ulat
ive
Ret
urn
Haugen’s Research
• Haugen no longer academic
• Sells portfolio management system based on IMH…
• Many other companies exploiting similar inefficiencies
• Eg, fractal trading systems…
Other approaches
• Not a product endorsement, but…– Shows theory of previous lecture used in
(successful?) trading strategies