8.3 Efficient Market Hypothesis Flashcards
An investor who practices indexing?
The investor purchases index mutual funds
Indexing and purchasing index funds tends to exhibit low administrative costs and a low turnover of existing assets.
The weak form of the efficient market hypothesis:
The weak form implies that information contained in historical stock prices is fully incorporated into current stock prices; therefore, technical analysis (the study of historical prices and volume) is not worthwhile in predicting future prices. This form neither refutes fundamental analysis nor implies that traders using insider information cannot earn superior profits.
Active portfolio management strategy
The goal of active portfolio management is to earn a return that exceeds the risk-adjusted return of a passive benchmark portfolio. This is net of transaction costs. Such a strategy also involves higher transaction costs and, usually, risk.
The P/E Effect:
The P/E effect suggests that portfolios consisting of stocks with low price-to-earnings ratios have higher average returns than do portfolios consisting of stocks with high P/E ratios.
Strong-form market efficiency:
Strong-form market efficiency suggests that all public and private information is included in market prices. A person who solicits private information believes that it is possible to profit by making trading decisions based on private information and does not believe that the markets are efficient in the strong form.
Weak-form efficiency
Weak-form efficiency suggests that all historical price and volume information is included in stock prices but that gains may be made by analyzing other publicly available information. An investor studying annual reports and analysts’ reports to make stock selections indicates that the person is conducting fundamental analysis, because the investor believes that the markets are weak-form efficient.
An individual who is a proponent of the efficient market hypothesis (EMH) will likely invest in what type of funds?
An individual who believes in the EMH will likely invest in index funds. Inherent in this strategy is a belief that an investor cannot outperform the market with active portfolio management techniques.
Richard has become very interested in the stock market and enjoys spending his spare time researching companies in the medical field. He believes studying and analyzing the industry, combined with his advanced exposure to trends and new innovations in medicine, will give him an advantage in achieving superior performance in medical stock investment opportunities. What type of EMH is Richard subscribing to?
Richard is subscribing to the weak form of the EMH because he believes fundamental analysis and insider information will yield superior performance.
An active portfolio strategy is based on
The stock market is inefficient. If the market is efficient, then a buy-and-hold strategy would be best. Only if the market is inefficient is it worth the costs involved in active management to attempt to generate superior returns.
Under the efficient market hypothesis, which of the terms best describes the movement of stock prices
The answer is random. Random walk is the term used to describe the pattern of movement of stock prices. Because only new information, which is unpredictable and random, will affect the price of a security, the pattern of price movements for a stock will be random
Characteristics associated with the market anomaly known as the neglected-firm effect?
Neglected firms are those that are neglected (not followed) by many financial analysts. When such companies can be found, the market for those companies may not be efficient, and investors who can take the time to analyze these companies may be able to take advantage of undervalued situations.
According to the arbitrage pricing theory (APT), the return on a stock represents?
The answer is the APT depends on the stock’s responsiveness to unexpected changes. The APT is related to the expected return on the stock. The APT is not reduced by the construction of diversified portfolios. The APT does not take into consideration the market return if the expected rate of inflation is realized.
The random walk hypothesis:
Any future price movement of a security will be based on any future information.
Future stock prices are random and do not follow any preestablished trend or path.
All the information up to the current time has been priced into a security
Roberta is a private investor who researches individual stock purchases thoroughly. She uses charts and historical price movement to determine entry and exit points for her stock trades. Based on her behavior, Roberta
Does not believe in the efficient market hypothesis (EMH) in any form.
One who believes that fundamental analysis can result in superior performance believes in the weak form of the EMH. The weak form states that all historical price information is fully reflected in the stock price, therefore technical analysis will not produce superior results.
The semistrong hypothesis states that neither fundamental nor technical analyses deliver superior performance.
The strong form states that all information, including insider knowledge, is already reflected in the stock price.
A client complains to you that his portfolio performance merely matched the market over the last few years, and questions whether the fees you charge him are justified when you haven’t outperformed the market. You try to explain to your client that he should base his performance expectations on the strong form of the efficient market hypothesis that states
neither fundamental nor technical analysis nor inside information will result in superior performance
