Efficient Market Theory

Question 1

Efficient Market Theory

Answer 1

According to this theory, it is not possible to beat the market as it is efficient based on all available information; however it assumes that everyone has access to the same information and have rational expectations

Question 2

Three forms of EMT

Answer 2

• Weak form: current price reflects all past market data, therefore technical analysis is useless and implies that fundamental analysis is worthwhile
• Semi-strong form: All public information eg financial statements is already reflected in the price, so fundamental analysis techniques is useless
• Strong form: All info including insider info is incorporated; therefore all types of analysis are futile

Question 3

Observations of perfectly efficient market

Answer 3

• Investors should expect fair return (no use to look for mispriced securities)
• There needs to be enough investors who believe that the markets are not efficient
• publicly known strategies cannot be expected to generate abnormal returns
• some investors will have impressive performance records mainly due to chance
• professionals investors would not be better than ordinary investors
• past performance is not indicative of future performance

Question 4

Observations on the Effects of transaction costs

Answer 4

• analysts can identify mispriced securities (but performance may be hampered by costs)
  -investors will buy and hold in a particular index and may do just as well by minimizing transaction costs

Question 5

Tests of market efficiencies

Answer 5

-Event: how quickly events/release of information affects prices
- Patterns searches: empirical regularities / market anomalies
- investment record of professional investors

Question 6

Data snooping

Answer 6

different people may interpret data and charts differently

Question 7

Abnormalities

Answer 7

• Seasonality (Monday lows, January highs
• Small firm
• Neglected firm
• Low P/E ratio

Try to sell stock late on Friday or early on Monday,
Purchase stocks of small firms in late December or earlier,
Sell stocks of small firms in mid-January or later,
Purchase stocks of large firms in early February or later,
Sell stocks of large firms in late December or earlier, and
Buy value stocks (low P/E) if holding over the entire business cycle.

Question 8

Under the Value Line phenomenon, what stocks would be expected to outperform the market over the next 6 to 12 months?

Answer 8

Stocks ranked 1 or 2 are forecasted to outperform the market over the next 6 to 12 months.