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for non-S&P factors in a manner similar to Elton, Gruber, Das, and Hlavka. He finds that there
is persistence in relative performance across managers but that much of the persistence seems
due to expenses and transaction costs rather than gross investment returns. This last point is
important: While there can be no consistently superior performers in a fully efficient market,
there can be consistently inferior performers. Repeated weak performance would not be due
to a tendency to pick bad stocks consistently (that would be impossible in an efficient mar-
ket!), but it could result from a consistently high expense ratio, high portfolio turnover or
higher-than-average transaction costs per trade. Carhart also finds that the evidence of per-
sistence is concentrated at the two extremes of the best and worst performers. Figure 8.7 from
Carhart™s study documents performance persistence. Equity funds are ranked into one of 10
groups by performance in the formation year, and the performance of each group in the fol-
lowing years is plotted. It is clear that except for the best-performing top-decile group and the
worst-performing tenth-decile group, performance in future periods is almost independent of
earlier-year returns. Carhart™s results suggest that there may be a small group of exceptional
managers who can with some consistency outperform a passive strategy, but that for the ma-
jority of managers, over- or underperformance in any period is largely a matter of chance.
Thus, the evidence on the risk-adjusted performance of professional managers is mixed at
best. We conclude that the performance of professional managers is broadly consistent with
market efficiency. The amounts by which professional managers as a group beat or are beaten
by the market fall within the margin of statistical uncertainty. In any event, it is quite clear that
performance superior to passive strategies is far from routine. Studies show either that most
managers cannot outperform passive strategies or that if there is a margin of superiority, it is
On the other hand, a small number of investment superstars”Peter Lynch (formerly of
Fidelity™s Magellan Fund), Warren Buffet (of Berkshire Hathaway), John Templeton (of
Bodie’Kane’Marcus: II. Portfolio Theory 8. The Efficient Market © The McGraw’Hill
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Fifth Edition

8 The Efficient Market Hypothesis

F I G U R E 8.7
Persistence of mutual
Decile 1
fund performance.
Performance over
time of mutual funds
groups ranked by
Average monthly excess return

initial year
Source: Marc M. Carhart,
0.2% “On Persistence in Mutual
Fund Performance,” Journal
of Finance 52 (March
1997), pp. 57“82.



Decile 10

Formation year 1 Year 2 Year 3 Year 4 Year 5 Year

Templeton Funds), and George Soros (of the Quantum Fund), among them”have compiled
career records that show a consistency of superior performance hard to reconcile with ab-
solutely efficient markets. Nobel Prize winner Paul Samuelson (1989) reviews this investment
hall of fame but concludes that the records of the vast majority of professional money man-
agers offer convincing evidence that there are no easy strategies to guarantee success in the se-
curities markets. The nearby box points out the perils of trying to identify the next superstar

So, Are Markets Efficient?
There is a telling joke about two economists walking down the street. They spot a $20 bill on
the sidewalk. One starts to pick it up, but the other one says, “Don™t bother; if the bill were real
someone would have picked it up already.”
The lesson here is clear. An overly doctrinaire belief in efficient markets can paralyze the
investor and make it appear that no research effort can be justified. This extreme view is prob-
ably unwarranted. There are enough anomalies in the empirical evidence to justify the search
for underpriced securities that clearly goes on.
The bulk of the evidence suggests that any supposedly superior investment strategy should
be taken with many grains of salt. The market is competitive enough that only differentially
superior information or insight will earn money; the easy pickings have been picked. In the
end, it is likely that the margin of superiority that any professional manager can add is so slight
that the statistician will not be able to detect it.
We conclude that markets are very efficient, but rewards to the especially diligent, intelli-
gent, or creative may be waiting.
Bodie’Kane’Marcus: II. Portfolio Theory 8. The Efficient Market © The McGraw’Hill
Essentials of Investments, Hypothesis Companies, 2003
Fifth Edition

Looking to Find the Next Peter Lynch?
TRY LUCK”AND ASK THE funds will beat Standard & Poor™s 500 stock index,
which is why market-tracking index funds make so
much sense.
As manager of Fidelity Magellan Fund from 1977 to So if you are going to try to identify star managers,
1990, Peter Lynch made a lot of money for sharehold- what should you do? First, stack the odds in your favor
ers. But he did a big disservice to everybody else. by avoiding funds with high annual expenses and sales
How so? Mr. Lynch had an astonishing 13-year run, commissions. Then kick the tires on those funds that
beating the market in every calendar year but two. He remain. Here are five questions to ask:
. . . gave hope to amateur investors, who had tried
• Does the fund make sense for your portfolio?
picking stocks themselves and failed. Now they had a
Start by deciding what sort of stock funds you want.
new strategy. Instead of picking stocks, they would pick
You might opt to buy a large-company fund, a small-
the managers who picked the stocks.
company fund, an international fund, and an emerging-
That was the theory. The reality? Every day, thou-
markets fund. Having settled on your target mix, then
sands of amateur investors, fund analysts, investment
buy the best funds to fill each slot in your portfolio.
advisers and financial journalists pore over the coun-
• How has the manager performed?
try™s 4,000-plus stock funds all looking for the next
Funds don™t pick stocks. Fund managers do. If a fund
Peter Lynch.
has a great record but a new, untested manager, the
They are still looking.
record is meaningless. By contrast, a spanking new fund
Falling Stars with a veteran manager can be a great investment.
The 44 Wall Street Fund was also a dazzling performer • What explains the manager™s good performance?
in the 1970s. In the 1970s, 44 Wall Street generated You want to invest with managers who regularly
even higher returns than Magellan and it ranked as the beat the market by diligently picking one good stock af-
third-best-performing stock fund. ter another. Meanwhile, avoid those who have scored
But the 1980s weren™t quite so kind. It ranked as the big by switching between stocks and cash or by making
worst fund in the 1980s, losing 73.1%. Past perfor- hefty bets on one market sector after another.
mance may be a guide to future results. But it™s a Why? If a manager performs well by picking stocks,
mighty tough guide to read. he or she has made the right stock-picking decision on
Fortunately, most stock funds don™t self-destruct with hundreds of occasions, thus suggesting a real skill. By
quite the vigor of 44 Wall Street. Instead, “superstar” contrast, managers who score big with market timing
funds follow a rather predictable life cycle. A new fund, or sector rotating may have built their record on just
or an old fund with a new manager, puts together a de- half-a-dozen good calls. With such managers, it™s
cent three-year or five-year record. A great feat? Hardly. much more difficult to say whether they are truly skillful
If a manager specializes in, say, blue-chip growth or just unusually lucky.
stocks, eventually these shares will catch the market™s • Has the manager performed consistently well?
fancy and”providing the manager doesn™t do anything Look at a manager™s record on a year-by-year basis.
too silly”three or four years of market-beating per- By doing so, you can see whether the manager has per-
formance might follow. This strong performance formed consistently well or whether the record is built
catches the media™s attention and the inevitable profile on just one or two years of sizzling returns.
follows, possibly in Forbes or Money or SmartMoney. By
• Has the fund grown absurdly large?
the time the story reaches print, our manager comes
As investors pile into a top-ranked fund, its stellar re-
across as opinionated and insightful. The money starts
turns inevitably dull because the manager can no
rolling in. That™s when the blue-chip growth stocks go
longer stick with his or her favorite stocks but instead
out of favor. You can guess the rest.
must spread the fund™s ballooning assets among a
growing group of companies.
Five Questions
I think it is possible to identify winning managers. But SOURCE: Reprinted with permission of The Wall Street Journal via
the odds are stacked against you. Over a 10-year pe- Copyright Clearance Center, Inc. © 1998 by Dow Jones & Company.
riod, maybe only a quarter of diversified U.S. stock All Rights Reserved Worldwide.

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Essentials of Investments, Hypothesis Companies, 2003
Fifth Edition

8 The Efficient Market Hypothesis

• Statistical research has shown that stock prices seem to follow a random walk with no SUMMARY
discernible predictable patterns that investors can exploit. Such findings now are taken to
be evidence of market efficiency, that is, of evidence that market prices reflect all
currently available information. Only new information will move stock prices, and this
information is equally likely to be good news or bad news.
• Market participants distinguish among three forms of the efficient market hypothesis. The
weak form asserts that all information to be derived from past stock prices already is
reflected in stock prices. The semistrong form claims that all publicly available
information is already reflected. The strong form, usually taken only as a straw man,
asserts that all information, including inside information, is reflected in prices.
• Technical analysis focuses on stock price patterns and on proxies for buy or sell pressure
in the market. Fundamental analysis focuses on the determinants of the underlying value
of the firm, such as current profitability and growth prospects. As both types of analysis
are based on public information, neither should generate excess profits if markets are
operating efficiently.
• Proponents of the efficient market hypothesis often advocate passive as opposed to active
investment strategies. The policy of passive investors is to buy and hold a broad-based
market index. They expend resources neither on market research nor on frequent purchase
and sale of stocks. Passive strategies may be tailored to meet individual investor
• Empirical studies of technical analysis generally do not support the hypothesis that such
analysis can generate trading profits. Some patterns are suggestive, but these would be
either expensive in terms of trading costs or can be due to time-varying risk premiums.
• Several anomalies regarding fundamental analysis have been uncovered. These include the
P/E effect, the small-firm effect, the neglected-firm effect, and the book-to-market effect.
• By and large, the performance record of professionally managed funds lends little
credence to claims that professionals can consistently beat the market.

book-to-market effects, 276 neglected-firm effect, 275 semistrong-form EMH, 265
efficient market passive investment small-firm effect, 274
hypothesis, 262 strategy, 267 strong-form EMH, 265
filter rule, 271 P/E effect, 274 technical analysis, 265
fundamental analysis, 266 random walk, 262 weak-form EMH, 265
index fund, 267 reversal effect, 272

1. Which of the following assumptions imply(ies) an informationally efficient market?
a. Many profit-maximizing participants, each acting independently of the others,
analyze and value securities.
b. The timing of one news announcement is generally dependent on other news

c. Security prices adjust rapidly to reflect new information.
d. A risk-free asset exists, and investors can borrow and lend unlimited amounts at the
risk-free rate.
2. If markets are efficient, what should be the correlation coefficient between stock returns
for two nonoverlapping time periods?
3. Which of the following most appears to contradict the proposition that the stock market
is weakly efficient? Explain.
a. Over 25% of mutual funds outperform the market on average.
b. Insiders earn abnormal trading profits.
c. Every January, the stock market earns above normal returns.
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Fifth Edition

288 Part TWO Portfolio Theory

4. Suppose, after conducting an analysis of past stock prices, you come up with the
following observations. Which would appear to contradict the weak form of the
efficient market hypothesis? Explain.
a. The average rate of return is significantly greater than zero.
b. The correlation between the market return one week and the return the following
week is zero.
c. One could have made superior returns by buying stock after a 10% rise in price and
selling after a 10% fall.
d. One could have made higher than average capital gains by holding stock with low
dividend yields.
5. Which of the following statements are true if the efficient market hypothesis holds?
a. It implies perfect forecasting ability.
b. It implies that prices reflect all available information.
c. It implies that the market is irrational.


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