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Questions and Answers
Which type of stock tends to outperform growth stocks?
What ratio is NOT mentioned as being beneficial for outperforming the market?
What phenomenon describes stock prices continuing to rise after favorable earnings announcements?
What implication does inefficiency in equity markets have for investors?
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Which of the following trends has been noted in the market post-2000?
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What typically happens to stock returns following good news announcements?
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Why might known market patterns become less effective over time?
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What characteristic distinguishes value stocks from growth stocks?
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What generally causes stock prices to increase?
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What does the weak-form efficient market hypothesis assert?
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Which hypothesis suggests that markets are expected to be at least weak-form efficient?
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Which of the following is NOT an assumption of the efficient market hypothesis?
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What can lead to stock prices not accurately reflecting available information according to the behavioral view?
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What does the strong form efficient market hypothesis assert about information?
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What is a consequence of simple profitable strategies existing in the market?
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What is meant by market inefficiency in financial markets?
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Study Notes
Stock Prices and Market Efficiency
- Stock prices tend to rise when there is positive news about a company's future prospects (expected cash flows) and decline when there is negative news.
- Investor sentiment and speculation can also influence stock price movements.
- The efficient market hypothesis (EMH) states that securities prices accurately reflect all available information, including future expected cash flows.
Forms of Efficient Market Hypothesis
- Weak-form EMH: All past market information is fully reflected in stock prices.
- Semi-strong form EMH: All publicly available information is fully reflected in stock prices.
- Strong form EMH: All information, public or private, is fully reflected in stock prices.
Market Efficiency in Practice
- In general, markets are expected to be at least weak-form and semi-strong form efficient.
- If simple profitable strategies existed, investors would use them, which would increase demand and ultimately eliminate the profit potential.
Behavioral Finance
- If investors act irrationally, markets may not fully reflect even publicly available information.
- Overconfident investors may underreact to company announcements because they rely heavily on their own opinions and underweight new information.
- Historical evidence suggests that there may be some degree of inefficiency in financial markets.
Evidence of Market Inefficiency
- Value stocks (stocks with tangible assets and current earnings) have historically outperformed growth stocks (stocks with lower current earnings but expected growth). This includes stocks with low price-to-earnings ratios, price-to-cash-flow ratios, and price-to-book-value ratios.
- Momentum in stock returns: Stocks that perform well in the past 6 to 12 months tend to continue outperforming.
- Over- and under-reaction to corporate announcements: Markets often react dramatically to company events, including positive earnings news. However, stock returns may continue to be positive even after favorable earnings announcements (post-earnings announcement drift).
Implications of Market Inefficiency
- If markets are inefficient, investors can potentially earn excess returns by exploiting mispricing.
- More recent evidence suggests that strategies exploiting these patterns have become risky and unsuccessful after 2000.
- The initial success followed by the eventual demise of such strategies indicates that once a pattern becomes known, investors will exploit it, ultimately eliminating that inefficiency.
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Description
Explore the dynamics of stock prices and the efficient market hypothesis (EMH) in this quiz. Understand how investor sentiment and various forms of EMH influence market behavior. Test your knowledge on how information impacts stock pricing.
