SOME LESSONS FROM CAPITAL MARKET HISTORY
Answers to Concepts Review and Critical Thinking Questions
1. 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.
2. 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.
3. No, stocks are riskier. Some investors are highly risk averse, and the extra possible return
doesn’t attract them relative to the extra risk.
4. 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
5. The market is not weak form efficient.
6. Yes, historical information is also public information; weak form efficiency is a subset of semi-strong
7. 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.
8. 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.
9. The EMH only says, 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 from the financial press.
10. a. 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 ii, iii, and iv, this information is fully impounded
in the current price and no abnormal profit opportunity exists.
b.Under ii, 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 ii is stronger than i, both imply that a profit opportunity exists; under iii and iv, this
information is fully impounded in the current price and no profit opportunity exists.
c.Under iii, if the market is not strong form efficient, then this information could be used as a
profitable trading strategy, by noting the buying activity of the insiders as a signal that the stock