Investment Theory - Note 8

What does EMH stand for?

Efficient Market Hypothesis.

What is the Efficient Market Hypothesis?

The idea that security prices reflect available information.

What is a random walk in stock prices?

Price changes are unpredictable because new information is unpredictable.

Why should stock price changes be unpredictable?

Predictable information should already be incorporated into prices.

What happens when investors expect a stock price increase?

Buying pressure tends to raise its price immediately.

What makes financial markets informationally efficient?

Competition among investors analyzing and trading on information.

What return should investors generally expect in efficient markets?

A normal return appropriate for the investment's risk.

Would reliably predictable abnormal stock returns challenge EMH?

Yes, if investors could exploit them after costs and risk adjustments.

Does EMH mean stock prices never change?

No. Prices change when new information arrives.

Why can takeover news affect stock prices rapidly?

Investors promptly incorporate the expected impact of the news.

What are the three forms of EMH?

Weak, semistrong, and strong.

What information is reflected under weak-form EMH?

All information contained in past trading history.

Which investment analysis is challenged by weak-form EMH?

Technical analysis based on past trading data.

What information is reflected under semistrong-form EMH?

All publicly available information.

Which investment analysis is challenged by semistrong-form EMH?

Fundamental analysis using publicly available information.

What information is reflected under strong-form EMH?

All information, including private inside information.

Which EMH form is the most demanding?

Strong-form EMH.

Which EMH form rules out abnormal profits from past prices alone?

Weak-form EMH.

Which EMH form predicts rapid adjustment to earnings announcements?

Semistrong-form EMH.

Which EMH form is challenged by profitable insider trading?

Strong-form EMH.

Does semistrong efficiency imply weak-form efficiency?

Yes. Public information includes past trading information.

Does strong-form efficiency imply semistrong efficiency?

Yes. It includes publicly available information.

What is technical analysis?

Using past price and trading patterns to forecast future prices.

What is another name for technical analysts?

Chartists.

What is a resistance level?

A price level above which an asset is thought unlikely to rise.

What is a support level?

A price level below which an asset is thought unlikely to fall.

Why might a widely discovered price pattern disappear?

Trading on the pattern can quickly eliminate the opportunity.

What is fundamental analysis?

Valuing securities using earnings, dividends, interest rates, and risk.

What is active portfolio management?

Seeking mispriced securities or forecasting market trends.

What is passive portfolio management?

Buying and holding a diversified portfolio.

Why does EMH support passive investing?

Consistently exploiting public information for abnormal profits is difficult.

Is portfolio management still useful in an efficient market?

Yes. Portfolios must still match investors' needs and risk tolerance.

What investor characteristics affect optimal portfolio choice?

Age, taxes, risk aversion, and employment circumstances.

What is the portfolio manager's role under strong market efficiency?

Tailor diversified investments to the investor rather than beat the market.

How can security mispricing harm the economy?

It can cause capital to flow toward inefficient uses.

How can overpriced securities affect corporate financing?

The issuing firm may raise capital too cheaply.

How can undervalued securities affect corporate investment?

The firm may reject projects because raising capital is too expensive.

What is a market anomaly?

A return pattern that appears inconsistent with market efficiency.

What is the magnitude issue in testing EMH?

Whether detected return opportunities are economically meaningful.

What is selection bias in investment performance tests?

Results may be distorted by which strategies or investors are observed.

What is the lucky event issue?

Some investors outperform by chance even without genuine skill.

What is serial correlation in stock returns?

A statistical relationship between returns in different periods.

What does positive serial correlation suggest?

Past positive returns tend to be followed by positive returns.

What is the momentum effect?

Recent winners and losers tend to continue their relative performance.

What horizon does Note 08 associate with momentum?

Approximately 3–12 months.

What is the long-term reversal effect?

Past extreme winners or losers tend to reverse relative performance.

What can explain short-term momentum and long-term reversal?

Possible overreaction or delayed adjustment to information.

What is the P/E effect?

A return anomaly associated with differences in price-to-earnings ratios.

What is the small-firm effect?

Small-company stocks have historically earned relatively high returns.

What is the January effect in Note 08?

The historical small-firm anomaly was concentrated in early January.

What is the book-to-market effect?

High book-to-market stocks have historically earned higher returns.

What is post-earnings-announcement drift?

Stock prices continue adjusting after an earnings announcement.

Why does earnings-announcement drift challenge semistrong EMH?

Public earnings information appears not to be fully reflected immediately.

What is the joint-hypothesis problem?

An anomaly may reflect either inefficiency or an incorrect risk model.

How do Fama and French interpret some anomalies?

As compensation for risks omitted by simpler models.

How do Lakonishok, Shleifer, and Vishny interpret anomalies?

As possible evidence of systematic forecasting errors and inefficiency.

What is data mining in tests of market efficiency?

Searching many patterns until some appear significant by chance.

Why should historical anomalies be interpreted cautiously?

They may reflect risk, chance, or statistical selection rather than mispricing.

Do we generally expect strong-form efficiency in real markets?

No. Inside information may provide an advantage.

What is inside information?

Material nonpublic information about a company.

What does the insider-trading evidence in Note 08 suggest?

Some insiders have earned profits from their informational advantage.

What is a useful test of professional investment skill?

Compare risk-adjusted results with a passive index strategy.

What bias has historically appeared in analysts' recommendations?

A tendency toward overly positive assessments.

Why might analyst recommendations move stock prices?

They may reveal information or create new buying and selling pressure.

Do mutual fund managers consistently beat passive indexes as a group?

No, according to the evidence discussed in Note 08.

What partly explains persistence in mutual fund performance?

Differences in expenses and transaction costs.

Does past superior fund performance prove persistent skill?

No. Much of it may be attributable to chance.

What is the overall conclusion of Note 08 about EMH?

Evidence is mixed and the value of active analysis remains debated.