Asset allocation

Question 1

Active management

Answer 1

–This can only be profitable if the investor has superior information and can manage risks better than the benchmark
–Profits should also cover the costs of active management

Question 2

Efficient Market Hypothesis (EMH)

Answer 2

–EMH says stock prices already reflect some level of available information
–A forecast about favorable future performance leads to favorable current performance, as market participants rush to trade on new information.
•Result: Prices change until expected returns are exactly commensurate with risk.

Question 3

Forms of market efficiency

Answer 3

Strong Weak= > private Information
Semi-strong => public information
Weak => past prices

Question 4

Weak form: technical analysis

Answer 4

Technical Analysis - using prices and volume information to predict future prices
–Success depends on a sluggish response of stock prices to fundamental supply-and-demand factors.
–Consistent with weak form efficiency

Question 5

Semi-strong form: Fundamental analysis

Answer 5

•Fundamental Analysis - using economic and accounting information to predict stock prices
–Try to find firms that are better than everyone else’s estimate.
–Try to find poorly run firms that are not as bad as the market thinks.
–Semi strong form efficiency and fundamental analysis

Question 6

Are Markets Efficient?

Answer 6

•Magnitude Issue
–Only managers of large portfolios can earn enough trading profits to make the exploitation of minor mispricing worth the effort (and cost).
•Selection Bias Issue
–Only unsuccessful investment schemes are made public; good schemes remain private.
•Lucky Event Issue

Question 7

Semi-strong Tests: Anomalies

Answer 7

P/E Effect
•Small Firm Effect (January Effect)
•Neglected Firm Effect and Liquidity Effects
•Book-to-Market Ratios
•Post-Earnings Announcement Price Drift
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Question 8

Well-known anomalies

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Answer 8

Momentum
–The idea of momentum in securities is that their price is more likely to keep moving in the same direction than to change directions
•Small firm effect
–Small firms outperform large ones on the long run
•January effect
–Under-performance in December and over performance in January due to tax considerations
•Neglected firm effect
•Days of the week effects,
–E.g. Friday announcement
•Reversals

Question 9

Bubbles and market efficiency

Answer 9

–Prices appear to differ from intrinsic values.
–Rapid run-up followed by crash
–Bubbles are difficult to predict and exploit
–E.g. bitcoin prices

Question 10

Anomalies over time

Answer 10

–Attempts to exploiting them move prices to eliminate abnormal profits
–Chordia, Subrahmanyam, and Tong (2014) study found attenuation of prominent equity return anomalies

Question 11

Strong-Form: Inside Information

Answer 11

• The ability of insiders to trade profitably in their own stock has been documented in studies
• SEC requires all insiders to register their trading activity
• Test: studies on insider trading

Question 12

Active

Answer 12

Active Management
–An expensive strategy
–Suitable only for very large portfolios

Question 13

Passive

Answer 13

Passive Management: No attempt to outsmart the market
–Accept EMH
–Index Funds and ETFs
–Very low costs

Question 14

So, Are Markets Efficient?

Answer 14

The performance of professional managers is broadly consistent with market efficiency.
•Most managers do not do better than the passive strategy.
•There are, however, some notable superstars:
–Peter Lynch, Warren Buffett, John Templeton, George Soros