Investments Exam 2 - Ch. 8&9

Which of the following statements are true if the efficient market hypothesis holds? A) It implies that future events can be forecast with perfect information. B) It implies that prices reflect all available information C) It implies that security prices change for no discernible reason D) It implies that prices do not fluctuate.

(B)

If markets are efficient, what role might a financial advisor serve? How about a stock analyst or portfolio manager?

--- A financial advisor may still be useful to help one diversify their portfolio, consider tax implications, explain different types of securities, how much to save, figure out how much risk is acceptable, suggest estate planning advice, etc. --- Market efficiency does not negate the role of financial analysts, portfolio managers, or financial advisors. However, it does suggest that portfolio managers would likely be better served by trading less (reducing costs and creating more long-term capital gains instead of short-term capital gains).

Even if prices follow a random walk, they still may not be informationally efficient. Explain why this may be true, and why it matters for the efficient allocation of capital in our economy?

--- A random walk means that the next price movement is not predictable in advance. Stocks follow a random walk with a positive drift which just implies that the average return is positive, but that the next period return for the stock market as a whole or any individual stock is not predictable. -- The reasonable explanation for this (and the reason consistent with EMH) is that all securities are fairly valued based on all currently available, relevant information and that new information is random. However, it could also be possible that stocks do not respond directly to information and merely bounce around based on noise. This would create a random walk.

After Polly Shrum sells a stock, she avoids following it in the media. She is afraid that it may subsequently increase in price. What behavioral characteristic does Shrum have as the basis for her decision making? A) Fear of regret B) Representativeness C) Mental accounting

A

Jill Davis tells her broker that she does not want to sell her stocks that are below the price she paid for them. She believes that if she just holds on to them a little longer, they will recover, at which time she will sell them. What behavioral characteristic does Davis have as the basis for her decision making? A) Loss aversion B) Conservativism C) Representativeness

A

Which one of the following would be a bullish signal to a technical analyst using moving average rules? A) A stock price closes above its 52-week moving average B) A stock price closes below its 52-week moving average C) A stock's moving average is increasing D) A stock's moving average is decreasing

A and C. A is more of a bullish signal while C is more confirmation of a bullish trend.

Moving Averages

A simple moving average just takes the average closing price for the last X days.

Match each example to one of the following behavioral characteristics A) Investors are slow to update their beliefs when given new evidence B) Investors are reluctant to bear losses due to their unconventional decisions C) Investors exhibit less risk tolerance in their retirement accounts versus their other stock accounts D) Investors are reluctant to sell stocks with "paper" losses E) Investors disregard sample size when forming views about the future from the past

A> Conservatism bias B> Regret avoidance C>Mental accounting D> Disposition effect E> Representativeness bias

At a cocktail party, your co-worker tells you that he has beaten the market for each of the last three years. Suppose you believe him. Does this shake your belief in efficient markets?

Again, not at all. This is no more surprising than someone flipping heads three times in a row (which, with a fair coin, should happen 1 in 8 times). --- Another possible explanation is that your co-worker prefers higher risk stocks. Because higher risk stocks should have higher expected returns, there is a greater chance of outperforming on any given year the nature of risk implies bigger upswings and downswings, so the years of underperformance could be significant as well. ----Finally your friend could be telling the truth as he believes it and not be telling the truth as it actually happened. Our brains tend to remember things that we want to remember better than things we don't. Therefore, it is easy to convince ourselves that we outperformed the market by forgetting one or two negative investments.

Candlestick and Bar Graphs

An open (or green) candlestick indicates that the close was higher than the open while a filled (or red) candlestick indicates the close was lower than the open. The lines above and below the body represent the high and low. A bar graph marks the high and low with a horizontal line at the close.

Would you consider yourself a Technical Analyst or a Fundamental Analyst with respect to your ideal approach to investing?

Both of these are chart patterns. A double-top is a chart pattern where the price appears to top out at the same price point two consecutive times (goes up to $X, falls back slightly, rises to $X again and then falls back again). This is a bearish indicator or sell signal that tells us the smart money stops buying and starts selling at that price meaning we should get out. A head-and-shoulders is a chart pattern where the price goes up to a certain point and then levels of or drops slightly, then rises to a higher point before leveling off and falling. It then levels off again at the price of the first shoulder before falling further. Again, this is a bearish indicator or sell signal.

Which of the following most appears to contradict the proposition that the stock market is weakly efficient? Explain. A) Over 25% of mutual funds outperform the market on average B) Insiders earn abnormal trading profits C) Every January, the stock market earns abnormal returns.

C because seasonal patterns are based on past price data (not fundamental information on the company) and using this past price data would (in this example) allow investors to outperform the market on a risk-adjusted basis.

Which of the following observations would provide evidence against the semistrong form of the efficient market theory? Explain. A) Mutual fund managers do not on average make superior returns B) You cannot make superior profits by buying (or selling) stocks after the announcement of an abnormal rise in dividends C) Low P/E stocks tend to have positive abnormal returns D) In any year approximately 50% of pension funds outperform the market.

C is the only situation where the use of publicly available information (low PE ratios) leads to abnormal returns. However, an alternative explanation could still come into play in that we may be incorrectly defining abnormal returns.

Which of the following phenomena would be either consistent with or a violation of the efficient markets hypothesis? Explain briefly. A) Nearly half of all professionally managed mutual funds are able to outperform the S&P 500 in a typical year. B) Money managers who outperform the market (on a risk-adjusted basis) in one year are likely to outperform in the following year. C) Stock prices tend to be predictably more volatile in January than in other months D) Stock price of companies that announce increased earnings in January tend to outperform the market in February. E) Stocks that perform well in one week perform poorly in the following week.

Consistent with: A and C Violation: B, D

In an efficient market, professional portfolio management can offer all of the following benefits except which of the following? A) Low-cost diversification B) A targeted risk level C) Low-cost record keeping D) A superior risk-return trade-off.

D Because markets are efficient, it is not possible to consistently identify "good" stocks to own or "bad" stocks to avoid. It is also not possible to time the market to identify when stocks as a whole are overvalued or undervalued. This implies that professional portfolio managers shouldn't be able to outperform the market,

What is meant by data mining, and why must technical analysts be careful not to engage in it?

Data mining is a problem because randomness can appear to have patterns if we look at enough different numbers.

What are your views on market efficiency?

I think markets are NOT efficient. There are several market inefficiencies that lead to overvalued/undervalued stocks and the opportunity for higher than risk adjusted rates of return. -----That being said, I think markets are reasonably efficient. while it is possible for a smart, knowledgeable investor to outperform the market, few will. By the time you factor in time, transaction costs, taxes, cost of information, etc. it is very difficult to get an edge and earn a higher return. Most people that claim to beat the market are similar to people that claim to beat the slot machines in Vegas. Either they have been lucky for a short period or they have selective memory. For the vast majority of investors (95% or more) the best investment strategy is to assume markets are efficient, maintain a diversified portfolio, adjusting allocations annually to match your risk profile while making regular savings (contributions) and minimizing costs.

If the trading volume in advancing shares on day 1 in the previous problem was 1.1 billion shares while the volume in declining shares was 0.9 billion shares, what was the trin statistic for the day? Was trin bullish or bearish?

If the trin is greater than 1, that is bearish and less than 1 is bullish. Since the trin is less than 1, this is a bullish indicator.

Yesterday, the DJIA gained 54 points. However, 1,704 issues declined while 1,367 advanced. Why might a technical analyst be concerned even though the market rose on this day?

Market breadth is considered an important technical tool to evaluate the strength of the market. Ideally, if the market is advancing, a broad advance (more stocks going up than down) indicate a healthier market. If the market is advancing, but more stocks are declining than going up, it is seen as a weak foundation for the market rise.

"Highly variable stock prices suggest that the market does not know how to price stocks." Respond.

NOT a valid statement. Instead it suggests that the expectations about the company's future performance are more uncertain and that the actual results varied far greater than anticipated.

A successful firm like Microsoft has consistently generated large profits for years. Is this a violation of the EMH?

Not at all. The efficient markets hypothesis says that all securities are fairly valued at all times based on all currently available, relevant information. It does not say anything at all about how well the companies themselves should perform. --- Companies that have historically performed better and are forecasted to continue to do so should have higher prices (higher relative to earnings, cash flows, etc.). Companies that have performed poorer historically and are expected to continue to do so, should be available cheaper --- The EMH merely says that the quality of the firm will be reflected in the stock price so that you can not just identify "good" companies (to buy) or "bad" companies to avoid because others have access to that same information and the "good" or "bad" characteristics are priced in.

Consider the following - On July 13, 2011, Netflix stock traded as high as $42 per share. A few short months later it was as low as $9.12 per share. On Oct. 26, 2015 it is at $103.

The idea of market efficiency is that stock prices are fairly valued based on all currently available information. That is not inconsistent with large price swings over time because new information can come out that would drastically alter a stocks value. ----Netflix, had significant new information about their pricing plans and subscribers, announcements of higher content costs (or loss of content providers) for streaming videos, and increased competition (Amazon Prime and others). Since then, they have seen rapid subscriber growth and successful original content that has caused investors to reimagine them as a rapid growth firm. All of this new information is what caused the stock price to drop.

How might someone who believes in market efficiency explain Warren Buffett and Bill Miller?

They could argue that they were identified after the fact and were lucky rather than good.

"If all securities are fairly priced, all must offer equal expected rates of return." Comment

This is NOT a valid statement as it ignores the riskiness of each security. As different securities have different levels of risk, it is reasonable for higher risk securities to have higher expected returns and lower risk securities to have lower expected return.

You know that firm XYZ is very poorly run. On a scale of 1 (worst) to 10 (best), you would give it a score of a 3. The market consensus is that the management score is only 2. Should you buy or sell the stock?

This is a great example of expectations and second-level thinking. You would buy the stock not because you think it is a great company. Instead, you would buy the stock because you think the market is too pessimistic which makes the stock undervalued.

Suppose you find that prices of stocks before large dividend increases show on average consistently positive abnormal returns. Is this a violation of the EMH?

This is not evidence against the EMH. Instead, it is evidence that investors are anticipating the positive news. There are two possible explanations for this. -- First is that investors are seeing the positive activity within the company that is leading the firm to raise dividends and properly anticipate that a positive announcement will be forthcoming. ---The alternative explanation is that the firms that are announcing the dividend increases have not kept that information under wraps as well as they should and people are trading on material, non-public information.

Discuss the following comment - "If markets are semi-strong form efficient, then the role of a stock analyst is useless and we might as well structure our portfolio by throwing darts at the WSJ."

WRONG! they still have several advantages to offer. --- 1) they can help investors manage risk. Market efficiency says that all stocks are fairly valued at all times based on currently available information. It does not say that all investments are equally risky. Some investors may prefer lower-risk, lower expected return securities while others may prefer higher-risk, higher expected return securities. --- 2) Finally, consider a market where there were no stock analysts or financial advisors. How likely would it be to be efficient? The process of everyone looking for inefficiencies is what creates a (mostly) efficient market. If everyone acted as if the market was efficient, it would not be.

Why might we expect markets to be efficient? Why might we expect markets to not be efficient?

We expect markets to be efficient because there are many value-maximizing traders/investors constantly looking for mispriced securities to buy/sell for abnormal profits. If there were overvalued stocks (obvious based on currently available, relevant information) then everyone would want to sell them (and no one would want to buy) causing the price to fall to fair value. If there were obviously undervalued stocks (obvious based on currently available, relevant information) then everyone would want to buy them (and no one would want to buy) causing the price to rise to fair value. These price corrections should take place immediately as people try to take advantage of the opportunity. Given the thousands of well-educated and experienced individuals looking for these mispriced securities, it is not likely that we are going to find opportunities that they missed. On the other hand, it appears that markets may not be 100% efficient so clearly everyone is missing something. What might be causing that? I would argue behavioral biases play a large part.

Good News, Inc., just announced an increase in its annual earnings, yet its stock price fell. Is there a rational explanation for this phenomenon?

Yes. it is basing performance on how the company is situated relative to expectations. If the firm was expecting earnings to rise by 20% and they only went up by 13%, they underperformed expectations and the market will treat this as bad news. ---- Another potential issue is that stocks are forward looking. Sometimes stocks respond positively to an earnings beat on the announcement, only to fall as the earnings release and/or conference call lowers future expectations.