Market Efficiency, Long-term Returns, and Behavioral Finance

By Eugene F. Fama, Kenneth R. French, David A. Hirshleifer, S. Kothari, O. Lamont, Mark L. Mitchell, H. Shefrin, Rex A. Sinquefield, Richard H. Thaler, T. Vermaelen and 1 more. 1997

Market efficiency survives the challenge from the literature on long-term return anomalies. Consistent with the market efficiency hypothesis that the anomalies are chance results, apparent overreaction to information is about as common as under-reaction, and post-event continuation of preevent abnormal returns is about as frequent as post-event reversal. Most important, consistent with the market efficiency prediction that apparent anomalies can be due to methodology, most long-term return anomalies tend to disappear with reasonable changes in technique. *Graduate School of Business, University of Chicago, 1101 East 58th St., Chicago, IL 60637. E-Mail eugene.fama@gsb.uchicago.edu. The comments of Kenneth French, David Hirshleifer, S.P. Kothari, Owen Lamont, Mark Mitchell, Hersh Shefrin, Rex Sinquefield, Richard Thaler, Theo Vermaelen, Robert Vishny, and two referees have been helpful. Event studies, introduced by Fama, Fisher, Jensen, and Roll (FFJR 1969), produce useful evidence on how stock prices respond to information. Many studies focus on returns in a short window (a few days) around a cleanly dated event. An advantage of this approach is that because daily expected returns are close to zero, the model for expected returns does not have a big effect on inferences about abnormal returns. The assumption in studies that focus on short return windows is that any lag in the response of prices to an event is short-lived. There is a developing literature that challenges this assumption, arguing instead that stock prices adjust slowly to information, so one must examine returns over long horizons to get a full view of market inefficiency. If one accepts their stated conclusions, many of the recent studies on long-term returns suggest market inefficiency, specifically, long-term under-reaction or over-reaction to information. It is time, however, to ask whether this literature, viewed as a whole, suggests that efficiency should be discarded. My answer is a solid no, for two reasons. First, an efficient market generates categories of events that individually suggest that prices over-react to information. But in an efficient market, apparent under-reaction will be about as frequent as over-reaction. If anomalies split randomly between underand over-reaction, they are consistent with market efficiency. We shall see that a roughly even split between apparent overreaction and under-reaction is a good description of the menu of existing anomalies. Second, and more important, if the long-term return anomalies are so large they cannot be attributed to chance, then an even split between overand under-reaction is a pyrrhic victory for market efficiency. We shall find, however, that the long-term return anomalies are sensitive to methodology. They tend to become marginal or disappear when exposed to different models for expected (normal) returns or when different statistical approaches are used to measure them. Thus, even viewed one-by-one, most long-term return anomalies can reasonably be attributed to chance. A problem in developing an overall perspective on long-term return studies is that they rarely test a specific alternative to market efficiency. Instead, the alternative hypothesis is vague, market inefficiency. This is unacceptable. Like all models, market efficiency (the hypothesis that prices fully reflect available information) is a faulty description of price formation. But following the

Citations in the corpus