38 - Equity Investment Flashcards
Which of the following statements best describes the overreaction effect?
The overreaction effect refers to stocks with poor returns over three to five-year periods that had higher subsequent performance than stocks with high returns in the prior period. The result is attributed to overreaction in stock prices that reverses over longer periods of time. Stocks with high previous short-term returns that have high subsequent returns show a momentum effect.
David Farrington is an analyst at Farrington Capital Management. He is aware that many people believe that the capital markets are fully efficient. However, he is not convinced and would like to disprove this claim. Which of the following statements would support Farrington in his effort to demonstrate the limitations to fully efficient markets?
If market prices are efficient there are no returns to the time and effort spent on fundamental analysis. But if no time and effort is spent on fundamental analysis there is no process for making market prices efficient. To resolve this apparent conundrum one can look to the time lag between the release of new value-relevant information and the adjustment of market prices to their new efficient levels. Processing new information entails costs and takes at least some time, which is a limitation of fully efficient markets.
Which of the following forms of the EMH assumes that no group of investors has monopolistic access to relevant information?
The strong-form EMH assumes that stock prices fully reflect all information from public and private sources. In addition, no group of investors has monopolistic access to information relevant to the formation of prices.
(Module 38.1, LOS 38.d)
The weak form of the efficient market hypothesis (EMH) implies that:
The weak form of the EMH implies that an investor cannot earn positive abnormal returns on average using technical analysis (market information), after adjusting for transaction costs and taxes. Evidence has shown that insiders can achieve positive abnormal returns on average, but this relates to the strong form of the EMH.
(Module 38.1, LOS 38.e)
The idea that uninformed traders, when faced with unclear information, observe the actions of informed traders to make decisions, is referred to as:
“Information cascades” refers to uninformed traders watching the actions of informed traders when making investment decisions. Herding behavior is when trading occurs in clusters, not necessarily driven by information. Narrow framing refers to investors viewing events in isolation.
If stock markets are semistrong-form efficient, a portfolio manager is least likely to create value for investors by:
Semistrong-form market efficiency implies that fundamental analysis of publicly available information will not generate abnormal returns on average. Portfolio managers should help quantify a client’s risk tolerances and return needs, offer portfolio policies and strategies to meet these needs, and construct a portfolio by allocating funds to appropriate asset classes. Portfolio managers can also create value by diversifying their clients’ portfolios globally to reduce risk, monitoring and evaluating changing capital market conditions, monitoring their clients’ needs and circumstances, and rebalancing their clients’ portfolios when necessary.
An efficient capital market:
An efficient capital market fully reflects all of the information currently available about a given security, including risk.
Under the efficient market hypothesis (EMH), the major effort of the portfolio manager should be to:
In an efficient market, portfolio managers must create and maintain the appropriate mix of assets to meet their client’s needs. The portfolio should be diversified to eliminate unsystematic risk. The appropriate systematic risk will depend on the clients risk tolerance and return requirement. Over time the needs of the client and environment will justify changes to the portfolio. The manager should also try to minimize transaction costs and at least try to match the performance of a benchmark.
