Efficient Market Hypothesis Flashcards
What is the Efficient Market Hypothesis?
- Stock price contains all known information
- the only way to outperform an index is to make riskier investments.
What happens when investors get their predictions wrong?
Overvaluation (bubble) or undervaluation
What is overvaluation?
Overly optimistic investors that drive prices up.
What is undervaluation?
Investors are very pessimistic and not willing to invest.
What are the efficient market hypothesis conditions?
- rationality
- compensating deviations from rationality
- arbitrage possibilities would immediately be known and disappear
When is the EMH more likely to hold?
In deeper, very liquid markets & for widely traded stocks.
What are the EMH stages?
- weak form
- semi-strong
- strong form
What is the weak form of the EMH?
All past data is incorporated in the price; technical analysis is useless
What is technical analysis?
Looking at past patterns in the movement of the stock and making decisions based on how the pattern is supposed to continue.
What is the semi-strong form of the EMH?
All public information is incorporated in the price; fundamental analysis is also useless
What is the strong form of the EMH?
All information is incorporated in the price.
What is the paradox of the EMH?
- no one can beat the market
- therefore, making active decisions is pointless - so follow an index (passive investing)
- however, if this happens the market will not be efficient anymore
What is the AAR?
Arithmetic Average Rate - normal average
What is the CAGR?
Compound Average Growth Rate (Geometric Mean)
How do we calculate CAGR?
CAGR = original value * (1+r)^n = new value (terminal value)
