Practice_Problems_8_Risk_and_Return - FIN340 PRACTICE...

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1 FIN340 PRACTICE PROBLEM SET 8 RISK AND RETURN 1. Bearing market efficiency in mind, how do you respond to the following comments? a. “Efficient markets, my eye! I know lots of investors who do crazy things.” An individual can do crazy things, but still not affect the efficiency of markets overall. The price of the asset in an efficient market is a consensus price as well as a marginal price. A nutty person can give assets away for free or offer to pay twice the market value. However, when the person’s supply of assets or money runs out, the price will adjust back to its prior level (assuming there is no new, relevant information released by his action). If you are lucky enough to know such a person, you will receive a positive gain at the nutty investor’s expense. You had better not count on this happening very often, though. Fortunately, an efficient market protects crazy investors in cases less extreme than the above. Even if they trade in the market in an “irrational” manner, they can be assured of getting a fair price since the price reflects all information. b. “Efficient markets? Balderdash! I know at least a dozen people who have made a bundle in the stock market.” Yes, and how many people have dropped a bundle? Or, more to the point, how many people have made a bundle only to lose it later? People can be lucky and some people can be very lucky; efficient markets do not preclude this possibility. Most likely, people tend to only tell about their investment success, while keeping their losses to themselves. c. “The trouble with efficient-market theory is that it ignores investors’ psychology such as the herding towards buying more and more high-technology stocks in the late 1990s.” Alluding to investor psychology can be a very slippery slope. Oftentimes it is used to explain particular price movements that one cannot explain otherwise. Even if investor psychology is responsible for particular price movements, is there any way to make money from it? That is, if investor psychology drives up the price one day, will it do so the next day also? Or will the price drop to a ‘true’ level? Almost no one can tell you beforehand what investor psychology will do. Theories based on it have little content. d. “Despite all the limitations, the best guide to a company’s value is its written-down book value. It is much more stable than its market value, given that the latter depends on market cycles and other temporary trends that are beyond the company’s control.”
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