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Security prices accurately reflect availableinformation, and respond rapidly to newinformation as soon as it becomesavailable

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Weak form efficiency: prices incorporate informationabout past prices

Semi-strong form: incorporate all publicly availableinformationStrong form: all information, including insideinformation

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Reasons to Think Markets Ought to

Be EfficientMarginal investor determines pricesSmart money dominates trading

Survival of fittest

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Reasons to Doubt these ReasonsMarginal investor: wealth mattersSmart money: matter of degree. Limits to arbitrage

theorySurvival of fittest: life cycle renews

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Psychological FactorsGambling behaviorOverconfidence

Slowness to make money, futility of career trying toprove others of ones ability

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Technical AnalysisRobert D. Edwards & John Magee, Technical Analysisof Stock Trends , 1948.

Hand drawing of charts, judgmental interpretation ofpatternsDifficult to test success of technical analysis

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Head & Shoulders PatternInitial advance attracts traders, upwardmomentum. Smart money begins to distributestock, trying not to kill demand.Eventually downturn, but smart money comes into support demand, manipulation. (left shoulder)Upward momentum resumes, ends when smart

money has distributed all shares; market drops.New traders try to exploit well-known tendency torally. New weak rally, right shoulder, then abreakout. (Edwards & Magee)

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Implications of Efficiency Allocational efficiency

If markets are not allocationally efficient thenperhaps there is a ________________________

___________ in capital markets.

role for greater governmentintervention

Possible rules changes to attempt to improveallocational efficiency

Tax on trading activityMore taxes on short holding period returnsChanges in corporate compensation

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Implications of EfficiencyInformational efficiency

If markets are not informationally efficient

Investors may not be able to trust that marketprices are up to date and investors shouldthen conduct their own research (or hire aresearcher) to validate the price.

Privileged groups of investors will be able to

consistently take advantage of the generalpublic.Active strategies could outperform passivestrategies.

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Relationships between forms ofthe EMH

Notice that _______________________________ __________________ (but _____________)

Strong form efficiency would imply that __________________________________________.

semi-strong efficiency implies weakform efficiency holds NOT vice versa

both semi-strong and weak form efficiency hold