SOME LESSONS FROM CAPITAL MARKET HISTORY
Answers to Concepts Review and Critical Thinking Questions
They all wish they had! Since they didn’t, it must have been the case that the stellar performance was not foreseeable, at
least not by most.
As in the previous question, it’s easy to see after the fact that the investment was terrible, but it probably wasn’t so easy
ahead of time.
No, stocks are riskier. Some investors are highly risk averse, and the extra possible return doesn’t attract them relative to
the extra risk.
On average, the only return that is earned is the required return—investors buy assets with returns in excess of the
required return (positive NPV), bidding up the price and thus causing the return to fall to the required return (zero NPV);
investors sell assets with returns less than the required return (negative NPV), driving the price lower and thus the
causing the return to rise to the required return (zero NPV).
The market is not weak form efficient.
Yes, historical information is also public information; weak form efficiency is a subset of semi-strong form efficiency.
Ignoring trading costs, on average, such investors merely earn what the market offers; the trades all have zero NPV. If
trading costs exist, then these investors lose by the amount of the costs.
Unlike gambling, the stock market is a positive sum game; everybody can win. Also, speculators provide liquidity to
markets and thus help to promote efficiency.
The EMH only says, that within the bounds of increasingly strong assumptions about the information processing of
investors, that assets are fairly priced. An implication of this is that, on average, the typical market participant cannot
earn excessive profits from a particular trading strategy. However, that does not mean that a few particular investors
cannot outperform the market over a particular investment horizon. Certain investors who do well for a period of time
get a lot of attention from the financial press, but the scores of investors who do not do well over the same period of
time generally get considerably less attention.
If the market is not weak form efficient, then this information could be acted on and a profit earned from following
the price trend. Under (2), (3), and (4), this information is fully impounded in the current price and no abnormal
profit opportunity exists.
Under (2), if the market is not semi-strong form efficient, then this information could be used to buy the stock
“cheap” before the rest of the market discovers the financial statement anomaly. Since (2) is stronger than (1), both
imply that a profit opportunity exists; under (3) and (4), this information is fully impounded in the current price
and no profit opportunity exists.