Investment Planning: Efficient Market Theory (Module 12)

What conclusions can be drawn from anomalies of efficient markets?

- Avoid buying stock late on Friday or early on Monday, - 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.

Observations about perfectly efficient markets?

- Investors should expect to make a fair return on their investment, but no more. - The need for non-believers - Publicly known investment strategies cannot be expected to generate abnormal returns. - Some investors will display impressive performance records. - Professional investors should fare no better in picking securities than ordinary investors. - Past performance is not an indicator of future performance.

Alfred's indifference curve is tangent to Markowitz's efficient frontier at point E (the maximum risk). What type of investments would interest him? 1. Hedge Funds 2. S&P 500 3. Mortgage REITs 4. Selling naked calls 5. Buying out of the money calls

1, 5 Selling naked calls only produces limited income. You get the premium income. Although risky, they do not produce much gain. But buying out of the money calls can produce tremendous gains if the calls go in the money. This is somewhat subjective. Answers II and III have moderate risk in the opinion of the writer.

If you believe in EMH, how should you invest? a. Consider reducing taxes and transaction costs by maintaining a chosen risk level of a portfolio over time. b. Use sector rotation. c. "Beat the market" by identifying undervalued securities. d. Attempt to time the market by identifying optimal buy and sell opportunities.

A If the stock market is efficient, prices reflect fair economic value as estimated by investors. In a market where prices depart only slightly from their fair economic value, investors should not employ various trading strategies.

What is the most fundamental, distinguishing characteristic of the Markowitz efficient frontier? a. Risk b. Covariance c. Correlation d. Return

A Return, covariance and correlation play a "supporting" role in determining the efficient frontier. But, risk is the most fundamental, distinguishing characteristic of the efficient frontier.

Modern portfolio theory has a risk-return relationship based on which of the following? a. Capital Market Line b. Correlated coefficient c. Security Market Line d. Alpha e. Weighted beta

A The CML specifies the relationship between the risk and return on a variably-weighted market portfolio consisting of all risky assets.

Lew believes in the value line phenomenon. He trades stocks buying when value line indicates and sells when value line indicates. What type of investor is he? a. Passive b. Active c. Believes in EMH. d. Believes he can outperform the market consistently on a risk- adjusted basis. e. Believes that price changes are unpredictable and patterns formed are accidental.

B Active is the best answer. He is actively buying and selling on value line ratings. EMH is passive views value line is an anomaly.

Harry is a highly risk averse investor. What does the shape of the indifference curve for Harry look like versus the curve for Stan, who is less risk averse? a. Harry has a relatively flat curve whereas Stan has a steep curve. b. Harry has a steep curve whereas Stan has a relatively flat curve. c. Both indifference curves are the same.

B Harry would demand a large amount of additional (expected) return to bear additional risk and maintain the same level of satisfaction (point A). Stan would be at point B (a relatively flat curve).

Tony Jackson is an investor who follows a buy-hold strategy. He also relies on in-depth research to reposition his portfolio from time to time. His research focuses on financial statement analysis. Which approach is he using? a. P/E effect b. Weak form of EMH c. Semi-strong form of EMH d. Strong form of EMH

B He follows fundamental analysis (which supports the weak form). It does not say he is factoring the P/E ratio to reposition his portfolio, and the tone of the question is passive.

The semi-strong form of the efficient market theory indicates which of the following? a. That investors react quickly and accurately to new information leading to quick and accurate price adjustments. b. That past performance is useless in predicting future price changes. c. That current prices reflect past prices and all publicly available information. d. That not even insider information will produce superior results over time.

C Semi-strong form: That current prices reflect past prices and all publicly available information. Strong form: That not even insider information will produce superior results over time. Weak form: That past performance is useless in predicting future price changes. Efficient market: That investors react quickly and accurately to new information leading to quick and accurate price adjustments.

Kim values individual assets using the SML required rate of return line. She uses it to buy and sell individual stocks; sometimes she even shorts stocks. She also believes in which form of EMH? a. None of the forms b. Strong form c. Weak form d. Semi-strong form

C She may be using fundamental analysis when she uses the SML. She is buying and selling individual stocks based on the required rate of return.

What happens when overconfidence meets the stock market? a. Financial talking heads express their brilliance. b. Buy-hold strategy becomes the norm. c. Turnover explodes. d. EMH theory becomes the norm.

C Stock markets should not exist in the extreme form of efficient market theory. If the price is right who would want to trade stocks? With overconfidence, an investor thinks they know more than everyone else. Yes, financial talking heads would express their brilliance, but the best answer to overconfidence is turnover exploding.

Which one of the following would best justify an investor hiring an active portfolio manager even though markets have been shown to be semi-strong form efficient? A. The existence of market "anomalies" has been discovered. B. Analysts have incorporated relevant information quickly and accurately. C. Technical trading rules have been proven to be ineffective. D. The results from studies on efficiency are debatable and not universally accepted.

Correct Answer: A. The existence of market "anomalies" has been discovered. Explanation: Various market "anomalies" have been discovered in tests of a semi-strong form market. Securities with certain characteristics or during certain time periods appear to produce abnormally high returns. The help of an active portfolio manager aware of such anomalies would help an investor. It is in highly efficient markets, such as the U.S., that analysts have incorporated information quickly and accurately. In weak form markets technical analysis based on past records has proved to be ineffective.

When a series of prices represents a situation in which changes in the value of the prices are independent and identically distributed, we refer to the series as a random walk. A. True B. False

Correct Answer: A. True Explanation: The random walk model is a situation in which changes in the value of a random variable are independent and identically distributed. When applied to common stocks, it refers to a situation in which security price changes are independent and identically distributed. This means that the size of a security's price change, from one period to the next, can be viewed as being determined by the spin of a roulette wheel.

Testing for market efficiency is often conducted using ____ where it can be seen how quickly security prices actually reach the next equilibrium from the release of new information. A. A pattern search B. Event studies C. Performance of professional investors D. Inside information

Correct Answer: B. Event studies Explanation: Event studies reveal how fast security prices react to release of information. Pattern searches and performance tests are methods used for testing other aspects of market efficiency. Inside information is not used in testing for market efficiency.

In a perfectly efficient market, analysts can gain abnormal returns by using special data and analytical software. A. True B. False

Correct Answer: B. False Explanation: Analysts may be able to show abnormal returns on their gross returns, but these gains will be offset by the increased cost incurred in using special data and analytical software. The resulting net returns will show that they have earned a fair return and nothing more.

A study of anomalies in the Tokyo Stock Exchange shows that apart from the size effect, none of the other anomalies found in the United States exist in Japan. A. True B. False

Correct Answer: B. False Explanation: In addition to the size effect, the January effect and the day-of-the-week effect also exist in Japan. This also includes the interrelationship between the January effect and size effect.

The day-of-the week effect states that: A. Small firms have lower returns on Monday. B. Stocks tend to open below their Friday closing prices on Monday. C. Stock returns in January are higher. D. Small firms have higher returns than larger firms.

Correct Answer: B. Stocks tend to open below their Friday closing prices on Monday. Explanation: The day-of-the-week effect shows that returns on Monday are lower and in the negative. The January effect and size effect indicate the other regularities. No regularity has been found stating that small firms have lower returns on Monday.

In perfectly efficient markets, the investors who profited in the past: A. Have a higher probability of profiting in the future B. Were most often lucky C. Learned valuable trading rules for the future D. Used professional advice

Correct Answer: B. Were most often lucky Explanation: Though some investment advisors or analysts may display impressive performance records, it is merely due to luck or chance. Their past performance cannot be relied upon as a basis for predicting their future performance.

What is the level of market efficiency, in which only previous security prices and volume data are reflected in current security prices, called? A. A strong form efficient market B. A semi-strong form efficient market C. A weak form efficient market D. A perfectly efficient market

Correct Answer: C. A weak form efficient market Explanation: A weak form efficient market exists when the market prices reflect only previous or historical information. In a semi-strong efficient market, the market prices reflect all public information. A strong form or perfectly efficient market exists when the market prices reflect everything that is knowable. This includes both historical and public information in addition to other information.

Which of the following statements is not true regarding the results of tests for market efficiency of U.S. securities markets? A. U.S. securities markets are highly efficient. B. Information about investment values is reflected quickly and accurately in security prices. C. No cases of abnormal returns have been identified. D. Abnormal profits cannot be expected by trading on public information.

Correct Answer: C. No cases of abnormal returns have been identified. Explanation: Tests for market efficiency of U.S. securities markets have shown that they are highly efficient. They quickly incorporate information to reflect changes in security prices. Therefore, investors cannot expect to earn abnormal profits by trading on publicly available information. Nevertheless, tests have also identified numerous pockets of unexplained abnormal returns that have caused many debates.

In a perfectly efficient market: A. Investors who have the resources should rely on investment advisors for pricing decisions. B. Investment analysts will be highly regarded and actively pursued for their advice. C. Professional investors should fare no better in stock selection than the uninformed investors. D. Professional investors have an edge in generating abnormally high returns.

Correct Answer: C. Professional investors should fare no better in stock selection than the uninformed investors. Explanation: In a perfectly efficient market, prices always reflect investment value, and hence, professional investors do not have an edge over ordinary investors when it comes to stock selection. Therefore, investors need not rely on investment advisors or analysts for pricing decisions.

What types of information do perfectly efficient prices reflect? 1. Historical information 2. Public information 3. Inside information of the company 4. Additional information that is more difficult to obtain

Correct Answers: 1, 2, 3, 4 Explanation: A strong form or perfectly efficient market exists when the market prices reflect everything that is knowable. This includes both historical and public information in addition to other information. Knowable information also includes inside information of the company. However, this must be used only in a legally approved manner.

Jack Jones is a professional investor. He wants to purchase stocks of Instapro and Deltapro. He also wishes to sell stocks of Techpro and Softpro. Instapro and Techpro are large firms while Deltapro and Softpro are small firms. According to the study of anomalies, he should: 1. Purchase stocks of Deltapro in late December or earlier. 2. Sell stocks of Deltapro in mid-January or later. 3. Purchase stocks of Softpro in late December or earlier. 4. Purchase stocks of Instapro in early February or later. 5. Sell stocks of Instapro in late December or earlier.

Correct Answers: 1, 4 Explanation: Market anomalies suggest that Jack Jones should: purchase stocks of small firms (Deltapro) in late December or earlier; sell stocks of small firms (Softpro) in mid-January or later; purchase stocks of large firms (Instapro) in early February or later; and sell stocks of large firms (Techpro) in late December or earlier.

Which the following is true about a perfectly efficient market with transaction costs? 1. Passive managers will out perform active managers 2. The net return of passive and active managers will be similar 3. Active managers' returns will be offset by cost to acquire information and make frequent trades

Correct Answers: 2, 3 Explanation: Active managers may be able to find better returns, but their costs for information and transactions will offset any additional gains. This will result in a similar net return for both passive and active managers.

Which of the following statements does not apply to an efficient market? 1. Investors generate price expectations for securities. 2. Under or overvaluation of securities can be expected. 3. Abnormal profits can be made by using a set of information to formulate buying and selling decisions. 4. Investors must make full and accurate use of the available information set.

Correct Answers: 2, 3, 4 Explanation: In an efficient market it is impossible to make abnormal profits by using a particular set of information to formulate buying and selling decisions. That is, investors should expect to make only normal profits by earning a normal rate of return on their investments. An efficient market is defined as one in which every security's price equals its investment value at all times. In an efficient market, a set of information is fully and immediately reflected in market prices.

Random Walk

Information arrives randomly in an efficient market. Investors incorporate new information immediately and fully in security prices. Consequently, security price changes are random.

The Fama's Formula

The Fama's Formula of the efficient market model is a notation describing how investors generate price expectation for securities. The equation states that expected price for a security at the end of a period is based on the security's expected normal rate of return during that period, which is determined by the information set available at the start of the period. Abnormal profits could not be earned if all information was available.

Value Line Investment Survey

The Value Line Investment Survey began in the early 1960s. Their basic service is equity research and is available by subscription. The service ranks the most widely traded 1,700 stocks into one of five categories. Stocks ranked 1 or 2 are forecasted to outperform the market over the next 6 to 12 months. Stocks ranked 3 are expected to return amounts that mirror the general market average, and stocks ranked 4 or 5 are expected to under perform the stock market returns over the next 6 to 12 months. Not allowing for taxes or transaction costs, an investor who committed to invest in stocks ranked 1 by Value Line, would have outperformed the Dow Industrial average by 20 fold, and the would have out performed the S&P 500 Index by 17 fold since the mid 1960s

In a perfectly efficient market, which of the following investment choices is the most logical for someone looking to invest in the stock market? a. contrarian stock funds b. momentum stock funds c. value funds d. stock index funds e. growth stocks

d. stock index funds

allocationally efficient markets

in which the firms with the most promising investment opportunities have access to the needed funds. However, in order for markets to be allocationally efficient, they need to be both internally and externally efficient.

The Holiday Effect

indicates that average stock returns on trading days around the annual federal holidays are far higher than on other days.

Low P/E Effect

indicates that over the business cycle, value investing has produced greater returns than growth investing. This contradicts the usefulness of active management in a perfectly efficient market.

externally efficient market

information is quickly and widely disseminated, thereby allowing each security's price to adjust rapidly in an unbiased manner to new information so that it reflects investment value.

internally efficient market

is one in which brokers and dealers compete fairly so that the cost of transacting is low and the speed of transacting is high.

The Day-of-the-week Effect (Weekend Effect)

shows that the average return on Monday was lower than the average return on any other day of the week and negative while the other days were positive.

The January Effect

states that the average return in January is higher than the average return in any other month

Efficient Market Model

states that the value of a security is a reflection of the information available about it. There are three forms: Weak Form, in which a security's price reflects historical data; Semi-strong Form, in which a security's price reflects historical and current public information; and Strong Form, in which a security's price reflects all information (past, present, public and insider).

EMH suggests that financial planners should direct their activities to selecting securities based on which of the following? a. Risk-return profile b. Security selection c. Technical analysis d. Fundamental analysis

A EMH implies that because analysts as a group are so effective, the efforts of an individual in trying to find mispriced securities may be a waste of time.

Market Efficient Price

A perfectly efficient price would react immediately to new information and adjust to the new price. Less efficient prices will react differently; some will overreact, while others may lag.

Neglected Firm Effect

An investor can out perform the market by investing in firms that are not followed by equity analysts.

Why is their a need for non-believers in an efficient market?

However, if everyone believed that markets are perfectly efficient, then everyone would realize that nothing is to be gained by searching for undervalued securities. Hence, nobody would bother to analyze securities. Consequently, security prices would not react instantaneously to the release of information but instead would respond more slowly. Thus, in a classic "Catch-22" situation, markets would become inefficient if investors believed that they are efficient, yet they are efficient because investors believe them to be inefficient.

Strong form, or perfectly efficient

It is impossible to make abnormal profits (other than by chance), by using any information (public or private) to make buying and selling decisions. In strong form, all types of analysis are rendered worthless, including insider information.

Weak form efficient

It is impossible to make abnormal profits (other than by chance), by using past prices to formulate buying and selling decisions. In weak form, technical analysis is rendered worthless.

Semi-strong form efficient

It is impossible to make abnormal profits (other than by chance), by using publicly available information to formulate buying and selling decisions. In semi-strong form, both technical analysis and fundamental analysis are rendered worthless.

Value Line Phenomena

Over the last 40 + years, the proprietary Value Line ranking method has dramatically out performed the major stock market indices.

How does the existence of these costs affect the efficient market model?

Sanford Grossman and Joseph Stiglitz considered this issue and arrived at two important observations about perfectly efficient markets with transactions costs: - In a world where it costs money to analyze securities, analysts will be able to identify mispriced securities. - Investors will do just as well using a passive investment strategy where they simply buy the securities in a particular index and hold onto that investment.

Semi-strong Information

Semi-strong Form, in which a security's price reflects historical and current public information;

Small Firm Effect

Small firms have higher returns than large firms, and their returns are higher in January than in any other month.

Strong Form Information

Strong Form, in which a security's price reflects all information (past, present, public and insider).

Weak Form Information

Weak Form, in which a security's price reflects historical data