Investment Planning - Efficient Market Theory (EMT)
In a perfectly efficient market, analysts can gain abnormal returns by using special data and analytical software.
- False 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.
Why would publicly known investment strategies not generate abnormal returns?
- The moment the strategy indicates that a security is mispriced, the price adjusts to become equal to the security's investment value. Publicly known investment strategies must have a way of identifying mispriced securities. Investors who know the strategy will definitely try to capitalize on it. This will have an immediate effect on security prices, forcing them to equal investment values. Thus, the usefulness of the strategy will be destroyed and it cannot generate abnormal returns any longer.
In perfectly efficient markets, the investors who profited in the past:
- Were most often lucky 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 strong form?
- a security's price reflects all information (past, present, public and insider)
What is semi-strong form?
- a security's price reflects historical and current public information
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.
- event studies 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.
What is the level of market efficiency, in which only previous security prices and volume data are reflected in current security prices, called?
- A weak form efficient market 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.
An analyst wants to test a semi-strong efficient market to see how it reacts to the public release of information relevant to the pricing of securities. Which method must he or she use?
- Event studies The event is the public release of the information and event studies indicate how fast the market reacts to release of information. The other methods — pattern searches and performance tests — indicate other aspects of market efficiency. Information signaling is not used in testing market efficiency.
Mary Ann believes the market is perfectly efficient. She should invest her money in a concentrated portfolio where the portfolio manager invests in twenty securities.
- False Consulting professional investors would incur extra transaction costs. This would offset any extra returns that an investor might gain. Since Mary Ann believes the market is efficient, she would do just as well using a passive investment strategy where she simply buys an index fund and holds on to that investment
What types of information do perfectly efficient prices reflect?
- Historical information - Public information - Inside information of the company - Additional information that is more difficult to obtain 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.
Random walk applies to an efficient market because:
- Information arrives randomly in an efficient market - Information is incorporated immediately, therefore, security price changes are random In an efficient market, abnormal profits cannot be expected. As information arrives randomly, it is immediately reflected in security prices. Hence, security price changes are random.
Which one of the following methods is not used to test for market efficiency?
- Investment newsletter surveys Event studies, pattern searches and professional performance are the three forms of testing used for market efficiency
Studies demonstrating the size effect show that the returns on small firms' equities are significantly higher than those on large firm's equities. In such studies the definition of size is indexed by:
- Market capitalization Market capitalization is the year-end market price per share times the number of common shares outstanding. It is used to measure the size of companies. The other options are not correlated to equity returns.
Which of the following statements is not true regarding the results of tests for market efficiency of U.S. securities markets?
- No cases of abnormal returns have been identified. 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.
Which of the following test results disprove a perfectly efficient market?
- Overreaction to new information - Professional investors who outperform market consistently - January Effect If there is a lag from new information due to a learning curve or over-reaction, then the market efficiency is less than perfect. In a perfectly efficient market, professional investors should not be able to consistently outperform the market, and market anomalies such as the January Effect should not exist.
In a perfectly efficient market:
- Professional investors should fare no better in stock selection than the uninformed investors. 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.
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:
- Purchase stocks of Deltapro in late December or earlier - Purchase stocks of Instapro in early February or later. 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.
In a perfectly efficient market, which of the following investment choices is the most logical for someone looking to invest in the stock market?
- Stock Index Funds In a perfectly efficient market, there is no opportunity to gain abnormal returns beyond the market. Therefore, a stock index fund would produce the most returns possible.
The day-of-the week effect states that?
- Stocks tend to open below their Friday closing prices on Monday 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.
Arguments presented to explain the interrelationship between January effect and size effect are:
- Tax selling - Window dressing Tax selling and window dressing are two arguments presented to explain the interrelationship between January effect and size effect. Undervaluation of stocks and the fact the January effect exists in Japan actually contradict these arguments.
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?
- The existence of market "anomalies" has been discovered. 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.
Which the following is true about a perfectly efficient market with transaction costs?
- The net return of passive and active managers will be similar - Active managers' returns will be offset by cost to acquire information and make frequent trades 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.
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. True or False?
- True 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.
Which of the following statements does not apply to an efficient market?
- Under or overvaluation of securities can be expected. - Abnormal profits can be made by using a set of information to formulate buying and selling decisions. - Investors must make full and accurate use of the available information set. 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.
What is weak form?
- a security's price reflects historical data
What is the neglected firm effect?
- an investor can out perform the market by investing in firms that are not followed by equity analysts
What are pattern searches?
- consistently repeated patterns of abnormal returns show incidences disprove randomness of a perfectly efficient market
What is the holiday effect?
- indicates that average stock returns on trading days around the annual federal holidays are far higher than on other days
What is the low p/e effect?
- indicates that over the business cycle, value investing has produced greater returns than growth investing - contradicts the usefulness of active management in a perfectly efficient market
What is the value line phenomenon?
- over the last 40 + years, the proprietary Value Line ranking method has dramatically out performed the major stock market indices.
What are event studies?
- reveal how quickly security prices react to release of information - The less time it takes for the security to reach its new equilibrium price, the more efficient the market is
What is 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
What is the small firm effect?
- small firms have higher returns than large firms, and their returns are higher in January than in any other month
What is the january effect?
- states that the average return in January is higher than the average return in any other month
What is the efficient market model?
- states that the value of a security is a reflection of the information available about it
