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# Conventional wisdom holds that financial markets are informa

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Conventional wisdom holds that financial markets are informa [#permalink]

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26 Nov 2012, 03:44
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Conventional wisdom holds that financial markets are informationally efficient—that stocks are always priced and traded at the intrinsic value of their underlying assets. Thus, investors cannot expect to achieve returns consistently in excess of average returns, given information that is publicly available at the time, without taking on large economic risks akin to gambling risks. In other words, one can only obtain higher returns by purchasing riskier investments, and not through expert timing or speculative stock selection. There are three major interpretations of this efficient market hypothesis: Weak Efficient Market Hypothesis (EMH), which holds that current prices for assets, such as stocks, bonds, and property, reflect all past prices, Semi-strong EMH, which argues that prices change instantly to reflect all new public information (such as news of a take-over or a change in fiscal policy), and Strong EMH, which claims that prices adjust perpetually to reflect hidden, insider information not yet made public.

Weak EMH holds that technical analysis, the analysis of past stock performance, will not consistently produce excess returns because future price movements are only determined by current share prices and information not contained in historical price data. Under this hypothesis, share prices demonstrate no serial dependencies (recognizable patterns) that can be exploited by investors. However, most financial analysts whose job it is to make recommendations about whether to buy, hold, or sell stocks point to research showing that some markets demonstrate trends, such as cycles, over time and moreover, that the longer the period of study, the higher the degree of trending.

Semi-strong EMH posits that prices adjust proportionally and near-instantaneously to reflect the most current public information. To disprove this hypothesis, analysts have looked for repeated or substantial changes immediately after an initial price change; these changes would indicate that there is some market reaction to the initial change leading to an adjustment period during which the market price of a stock and its true value are not perfectly matched. If it were found, this adjustment period could theoretically be capitalized upon through fundamental analysis—the assessment of market information—and strategic timing. Investors and computer scientists who recognize this possibility have constructed complex algorithms to discover opportunities for arbitrage, the practice of capitalizing on price differences between markets that may occur only for milliseconds.

Strong EMH claims that the market is perfectly efficient in terms of all private and public information. Investors who have consistently gained excess returns are often used as examples to disprove Strong EMH (and to prove that strategy can yield excess returns), though a solid refutation generally follows from proponents of Strong EMH: among thousands of investors, some will succeed based on pure chance, rather than expert stock selection, purchase timing, or discrepancies between the true and market values of stocks. Thus, proponents of Strong EMH claim, the fact that investors sometimes see high returns does not, in and of itself, disprove even the Strong EMH hypothesis.
According to the passage, someone who believes in the Weak Efficient Market Hypothesis would agree with all of the following statements EXCEPT
[A] One can only obtain higher returns by assuming more risk.
[B] Knowledge of historical price data will not significantly enhance an investor’s capacity to achieve excess returns consistently.
[C] Historical price data does not contain information that would determine future price movements.
[D] Technical analysis is not a productive strategy for gaining excess returns consistently.
[E] New market information concerning an important take-over would be immediately reflected in the current price of a share.

[Reveal] Spoiler:
E

It can be inferred from the passage that those who believe in the validity of Semi-Strong EMH would agree with which of the following statements?
(A) Investors who have not consistently gained excess returns should improve their stock selection and timing.
(B) Analysis of historical price data and new market information is the best strategy for consistently gaining excess returns.
(C) In the absence of new information released to the public, stock prices will not adjust substantially immediately following an initial change.
(D) Algorithms that calculate arbitrage opportunities could be effective because the market value of a stock tends toward the intrinsic value of that stock.
(E) Fundamental analysis is likely to yield excess returns on a consistent basis.

[Reveal] Spoiler:
C

[Reveal] Spoiler: Question #1 OA
[Reveal] Spoiler: Question #2 OA

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Re: Conventional wisdom holds that financial markets are informa [#permalink]

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26 Nov 2012, 04:22
IMO
1. D
2. A (guessed)

I took 8 min the prob was i read first para completely i should have read the question and then moved on....Q 2 was bit difficult
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Re: Conventional wisdom holds that financial markets are informa [#permalink]

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26 Nov 2012, 04:36
Hi Carcass

Waiting for OA
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Re: Conventional wisdom holds that financial markets are [#permalink]

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01 Mar 2013, 23:56
A

The WHE did not discuss risky investments but all the other choices were tackled.

C

The prices react to all new public info. This is the trigger of price change.
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Re: Conventional wisdom holds that financial markets are [#permalink]

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28 Apr 2013, 19:34
1) D is too strong, and technical analysis and its efficiency are not discussed, at least in second paragraph.

2) C
as stated in paragraph 2 that prices adjust to reflect the most current public information, if there is no news then stock prices would not be adjusted, immediately following an initial change.
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Re: Conventional wisdom holds that financial markets are [#permalink]

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30 Apr 2013, 14:05
grandtheman wrote:
1) D is too strong, and technical analysis and its efficiency are not discussed, at least in second paragraph.

2) C
as stated in paragraph 2 that prices adjust to reflect the most current public information, if there is no news then stock prices would not be adjusted, immediately following an initial change.

OA is E & C

This passage is in knewton.
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Re: Conventional wisdom holds that financial markets are [#permalink]

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11 May 2013, 00:49
can someone please explain why A does not fit the first question?
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Re: Conventional wisdom holds that financial markets are [#permalink]

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11 May 2013, 01:23
Hi - the reason I think A is not correct is in the opening paragraph.

Whilst it's not specifically the section on the 'weak' it is referring to 'conventional wisdoms' which is then divided down into 3 groups. I.e all 3 groups believe I the conventional wisdom...

Does that make sense?
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Re: Conventional wisdom holds that financial markets are [#permalink]

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11 May 2013, 10:18
Thanks. I did not read the first para carefully..

This is what I missed - " In other words, one can only obtain higher returns by purchasing riskier investments, and not through expert timing or speculative stock selection. There are three major interpretations of this efficient market hypothesis: "

This indirectly suggests risk is a key factor..
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Re: Conventional wisdom holds that financial markets are informa [#permalink]

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17 Nov 2013, 01:51
Can anyone explain why E for q1?
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Re: Conventional wisdom holds that financial markets are informa [#permalink]

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21 Nov 2013, 07:55
HI Roopika,

Sure...

So this is a question on the weak form of EMH.

The passage explains that this is essentially that past performance of a stock can not be used to predict future prices. I.e. past performance has no impact.

So for this to hold, we must be looking about evidence about past prices.

E is the only one that doesn't do this - it talks about new information, whether or not this is in the price is irrelevant for weak EMH

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Re: Conventional wisdom holds that financial markets are informa [#permalink]

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01 Oct 2014, 06:20
For question 1 , why can't a) be the answer?
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Re: Conventional wisdom holds that financial markets are informa [#permalink]

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01 Oct 2014, 12:24
Tough one to read, took more time but got both the answers right

1) E (Detail question type)
2) C (Inference question type)
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Re: Conventional wisdom holds that financial markets are informa [#permalink]

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15 Jul 2015, 04:40
plumber250 wrote:
Hi - the reason I think A is not correct is in the opening paragraph.

Whilst it's not specifically the section on the 'weak' it is referring to 'conventional wisdoms' which is then divided down into 3 groups. I.e all 3 groups believe I the conventional wisdom...

Does that make sense?

could you please clarify this.

in para 2 for Weak EMH nothing is mention for risk.
and in option A we are talking about risk. Please clarify this.

Thanks
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Conventional wisdom holds that financial markets are informa [#permalink]

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17 Jul 2015, 14:09
[A] One can only obtain higher returns by assuming more risk.
vs.
[E] New market information concerning an important take-over would be immediately reflected in the current price of a share.

For question (1), the answer must be E and not A, because only historic data is known, and there's no way to predict the future price of stock(s). Your best bet of large gains is to assume heavy risk for higher gains. The first paragraph refers to it, which is part of the weak hypothesis' definition; furthermore, the answer is consistent with (1). Whereas, answer choice E states the point of the Semi-Strong hypothesis. The keyword is "immediately" - the Weak hypothesis never mentions anything about immediate reaction to current info, only a general reaction to current info; the immediate reaction to public info is exactly what differentiates the Semi-Strong from the other two hypotheses.

For question (2), I disagree with the OA as C:

[C] In the absence of new information released to the public, stock prices will not adjust substantially immediately following an initial change.

Notice that choice C is a very general effect - if it specifically stated that stock prices will not adjust substantially immediately following an initial change due to public info, then that answer is consistent with the Semi-Strong (S-S) hypothesis and thus correct. If you believe in the S-S hypothesis, then only public info should affect future stock prices in order to make reliable/consistent predictions, and all new public info is immediately registered in the stock price. However, the S-S hypothesis doesn't reject the affects of private info. In fact, paragraph one states that the Efficient Market Hypothesis assumes and thus applies only to publicly available information (note: the Strong hypothesis explicitly modifies this assumption by also assuming private info). It is still possible, then, that the absence of public info may still substantially alter the value of a stock through info privy only to private parties, e.g. insider trading. The S-S hypothesis will assert that independent investors won't know this private info to consistently, let alone once, take advantage of future stock prices (as soon as they know, it becomes public by definition).

Moreover, the EMH also doesn't reject risky investors. In fact, by asserting that risky stock gambles are the only way to beat the stock's average returns, the S-S EMH followed admits and acknowledges the existence of risky behavior of some investors, or at least the possibility of it. Then, risky behavior may cause stocks to rise after an initial price change. An avid believer of the S-S EMH won't simply assume that the market functions with only risk-averse investors and with only public information affecting stock prices. If one were to, then answer choice A in Q1 needs to be considered. Simply put, the S-S EMH only applies under its given conditions and thus stock prices can be affected by outside factors.

Note that choice C is consistent with the Strong hypothesis, in that private info may substantially affect current stock prices in the absence of any new public info, because new private info may follow. This logic is not contradictory with the logic given for question 1's answer choice E (immediate reaction vs general reaction to determine future price), because Q2's answer choice C is very general, and not as specific as in Q1's answer choice.

None of the answer choices for (2) are technically correct.
Conventional wisdom holds that financial markets are informa   [#permalink] 17 Jul 2015, 14:09
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# Conventional wisdom holds that financial markets are informa

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