Investments, tenth edition

12 

1

  THE EFFICIENT MARKET 

hypothesis makes 

two important predictions. First, it implies 

that security prices properly reflect whatever 

information is available to investors. A second 

implication follows immediately: Active trad-

ers will find it difficult to outperform passive 

strategies such as holding market indexes. To 

do so would require differential insight; this 

in a highly competitive market is very hard to 

come by. 

 Unfortunately, it is hard to devise measures 

of the “true” or intrinsic value of a security, 

and correspondingly difficult to test directly 

whether prices match those values. Therefore, 

most tests of market efficiency have focused 

on the performance of active trading strate-

gies. These tests have been of two kinds. The 

anomalies literature has examined strate-

gies that apparently  

would  have provided 

superior risk-adjusted returns (e.g., investing 

in stocks with momentum or in value rather 

than glamour stocks). Other tests have looked 

at the results of  actual  investments by asking 

whether professional managers have been 

able to beat the market. 

 Neither class of tests has proven fully con-

clusive. The anomalies literature suggests 

that several strategies would have provided 

superior returns. But there are questions as to 

whether some of these apparent anomalies 

reflect risk premiums not captured by simple 

models of risk and return, or even if they 

merely reflect data mining. Moreover, the 

apparent inability of the typical money man-

ager to turn these anomalies into superior 

returns on actual portfolios casts additional 

doubt on their “reality.” 

 A relatively new school of thought,  behav-

ioral finance,  argues that the sprawling litera-

ture on trading strategies has missed a larger 

and more important point by overlooking 

the first implication of efficient markets—the 

correctness of security prices. This may be the 

more important implication, because market 

economies rely on prices to allocate resources 

efficiently. The behavioral school argues that 

even if security prices are wrong, to exploit 

them still can be difficult and, therefore, the 

failure to uncover obviously successful trad-

ing rules or traders cannot be taken as proof 

of market efficiency. 

 Whereas conventional theories presume 

that investors are rational, behavioral finance 

starts with the assumption that they are not. 

We will examine some of the information-

processing and behavioral irrationalities 

uncovered by psychologists in other contexts 

and show how these tendencies applied to 

financial markets might result in some of the 

anomalies discussed in the previous  chapter. 

   CHAPTER TWELVE