CHAPTER 9 – Market efficiency
1. In an efficient market, the only means of achieving high returns is to invest in
high-risk securities. T
2. In an efficient market, fundamental analysis still provides value to an investor. T
3. If stock prices move randomly, charting and technical analysis are useful
investment tools. F
4. Recent academic studies in behavioral finance confirm that markets are even more
efficient than previously believed. F
5. The efficient market hypothesis means that trades can be executed quickly, easily,
and inexpensively. F
6. Advocates of the weak-form efficient market hypothesis claim that past price
movements are the best predictors of future price movements. F
7. Available evidence does not support the strong form of the efficient market
hypothesis. T
8. Even if the semi-strong form of the efficient market hypothesis is true, trading on
illegal insider information may lead to abnormal profits. T
9. The market reaction to quarterly earnings announcements tends to support the
strong form of the efficient market hypothesis. F
10. Behavioral finance suggests that investors react to new information in an efficient
manner such that security prices accurately reflect the new information.F
11. Fund managers tend to have too little confidence in their abilities leading them to
be excessively cautious.F
12. Individuals tend to invest in mutual funds that have recently been performing well.
T
13. Analysts tend to issue similar recommendations on individual securities.T
14. Self attribution bias causes investors to attribute their successes to skill and
failures to chance.T
15. There is strong evidence that investors who trade frequently outperform the
market. F
16. Some behavioral characteristics cause investors to realize lower investment
returns. T
17. Historically higher returns on the stocks of small companies can be completely
explained by their higher risk. F
18. Investors skilled in exploiting behavioral errors and market anomalies can
consistently outperform the market by a wide margin. F
19. Evidence suggests that growth stocks tend to outperform value stocks. F
20. Stocks of small companies have a historical tendency to do especially well in the
month of January. T
21. A principal objective of technical analysis is trying to determine when to invest. T
22. Investors should never combine fundamental analysis and technical analysis. F
23. Resources for technical analysis are readily available on the internet. T
24. For technical analysts, the forces of supply and demand have an important effect
on the prices of securities. T
25. The Dow Theory is used to predict when the markets will change direction based
on the long-term trends in the market. F
26. Investors who live in cities with NFL teams should be especially happy when their
team wins the Super Bowl. T
27. The stock market is considered strong when the market volume decreases in a
declining market. T
28. Market volume is a function of market demand for and supply of stocks. T
29. The breadth of the market refers to the spread between the number of stocks
advancing and those declining in value. T
30. A relatively high level of short sells is an indicator of a current bull market. F
31. The odd-lot theory supports buying into the market when the number of odd-lot
trades rises. F
32. Technical analysis is a mechanical approach to investing. T
33. You are most likely better off doing the opposite of what most investment
newsletter experts advise doing. T
34. An oversold market is generally considered to be overvalued. F
35. Charts are only used to confirm past trends. F
36. Charts are useful as a means of spotting developing trends. T
37. The relative strength index compares a security's price relative to itself over a
period of time. T
38. Point-and-figure charts have no time dimension. T
39. The simple moving average is a weighted average. F
40. Point-and- figure charts and moving averages both reduce the effect of random,
short-term market fluctuations. T
41. The mutual fund cash ratio (MFCR) compares the percentage of an investor's
portfolio held in cash to the percentage held in mutual funds. F
42. The advance/decline line is be used to time both the purchase and the sale of
securities. T
1. True — In an efficient market, securities are priced fairly based on all available information.
Therefore, the only way to achieve higher returns is by accepting higher risk. Risk and return are
directly related according to modern portfolio theory. Low-risk securities tend to offer lower
expected returns.
2. True — Even in an efficient market, fundamental analysis can help investors tailor
investments to their goals and risk preferences. It also helps avoid poor investments and develop
an informed understanding of companies. Though mispricing is rare, good analysis can still lead
to better asset allocation and portfolio decisions.
3. False — If stock prices move randomly as the random walk theory suggests, then past price
patterns offer no predictive value. Technical analysis depends on identifying trends in historical
prices. Therefore, charting and technical analysis would not be useful in truly random markets.
The efficient market hypothesis opposes the usefulness of these methods.
4. False — Behavioral finance studies have revealed that markets are not perfectly efficient.
Investors often behave irrationally due to biases such as overconfidence or herd behavior. This
challenges the notion that markets are becoming "more efficient."
5. False — The efficient market hypothesis refers to the informational efficiency of prices, not to
the mechanics of trading. Fast and cheap trading relates more to market structure, not to whether
prices reflect all information. Although improvements in trading platforms have made
transactions quicker, this is separate from market efficiency in the academic sense.
6. False — Advocates of the weak-form efficiency claim that all past price information is
already reflected in stock prices. Therefore, they argue that past price movements cannot predict
future movements. Technical analysis based on past trends would thus be ineffective under the
weak-form hypothesis.
7. True — Evidence suggests that insider information and private information can yield
abnormal returns, which contradicts strong-form efficiency. In a strong-form efficient market,
even insider information would be reflected in prices. Since insider trading can still be profitable,
strong-form efficiency does not fully hold in practice.
8. True — Even if the semi-strong form holds, meaning all public information is priced in,
illegal insider information is private and undisclosed. Trading on such information could lead to
abnormal profits because the market has not yet adjusted. Thus, insiders could outperform the
market before the information becomes public.
9. False — Market reactions to quarterly earnings announcements show that new information
can cause significant stock price movements. This suggests that all information, especially
private or insider details, is not always immediately reflected in prices. Therefore, these reactions
challenge strong-form market efficiency.
10. False — Behavioral finance shows that investors do not always react efficiently to new
information. Emotions like fear, greed, and cognitive biases often distort decision-making. As a
result, prices can overreact or underreact to news, causing temporary mispricings.
11. False — Studies show that fund managers often exhibit overconfidence in their skills, not
excessive caution. This overconfidence leads to more trading and sometimes worse results.
Rather than being too cautious, many fund managers believe they can consistently outperform
the market, which research disproves.
12. True — Investors often chase performance by pouring money into mutual funds that have
recently performed well. This behavior is linked to recency bias, where recent events are given
too much weight. However, past performance is not a reliable indicator of future results, as
markets tend to revert to mean returns.
13. True — Analysts often issue similar recommendations on securities, a phenomenon known
as herding behavior. Fear of being wrong alone, as opposed to wrong together with others, drives
this behavior. It results in a lack of independent analysis and contributes to market inefficiencies.
14. True — Self-attribution bias causes investors to attribute successful outcomes to their own
skill and failed investments to bad luck. This bias reinforces overconfidence and can lead to poor
decision-making. It also contributes to excessive trading and unnecessary risk-taking.
15. False — Empirical studies show that investors who trade frequently tend to underperform the
market. Trading costs, taxes, and behavioral biases erode returns. Overtrading often results from
overconfidence and market misjudgment rather than skillful investment.
16. True — Behavioral characteristics like overconfidence, loss aversion, and herd behavior
often lead investors to make poor decisions. These behaviors cause excessive trading, poor
timing, and misallocation of assets. Consequently, they typically realize lower investment returns
than more disciplined investors.
17. False — Higher returns from small-cap stocks cannot be explained solely by higher risk.
Some of the premium may arise from market inefficiencies or behavioral factors. The small-firm
effect suggests that small companies outperform for reasons beyond simple risk measures.
18. False — While skilled investors may exploit inefficiencies, consistently outperforming the
market by wide margins is very difficult. Market anomalies are often small and short-lived.
Transaction costs and competition from other traders reduce the ability to consistently gain
abnormal returns.
19. False — Historically, value stocks have tended to outperform growth stocks over long
periods. Value stocks are often undervalued relative to fundamentals, providing higher returns as
markets correct mispricings. Growth stocks, despite high expectations, often underperform due
to overly optimistic projections.
20. True — The "January effect" refers to the historical pattern where small-cap stocks tend to
perform especially well in January. This anomaly is partly attributed to year-end tax-loss selling
and new year rebalancing. It represents one of the earliest discovered calendar effects in finance.
21. True — A key objective of technical analysis is to determine the best timing for buying or
selling securities. Technical analysts study price patterns and trading volumes to anticipate
market movements. They focus on when to invest, rather than on what to invest in.
22. False — Many investors combine fundamental and technical analysis to make better
decisions. Fundamental analysis helps determine what to buy, while technical analysis helps
decide when to buy or sell. Combining both methods can improve investment timing and reduce
risk.
23. True — Resources for technical analysis, such as price charts, indicators, and tutorials, are
widely available online. Many financial websites offer free and paid tools for technical analysis.
These resources have become accessible to individual investors as well as professionals.
24. True — Technical analysts believe that supply and demand forces drive price movements.
They study trading volume, price trends, and order flow to assess market sentiment. Changes in
supply and demand are key signals for price direction.
25. False — The Dow Theory focuses on confirming major market trends, not predicting exact
market turning points. It analyzes the movements of the Dow Jones Industrial and Transportation
Averages to assess the strength of bull or bear markets.
26. True — Studies suggest that local investor sentiment can be influenced by unrelated events,
like a favorite sports team winning. After a Super Bowl win, investor optimism can cause
increased buying activity and short-term market gains in cities with winning teams.
27. True — When market volume decreases during a market decline, it suggests that selling
pressure may be weakening. This can be interpreted as a sign of market strength and a potential
bottoming process. Higher volume would usually confirm a stronger downtrend.
28. True — Market volume reflects the supply and demand for stocks. High volume usually
indicates strong investor interest and conviction, while low volume suggests uncertainty or lack
of consensus. Changes in volume often precede changes in price trends.
29. True — The breadth of the market is determined by comparing the number of advancing
stocks to declining stocks. Strong market breadth indicates widespread participation in a rally,
while weak breadth may signal a fragile market advance.
30. False — A high level of short selling usually indicates bearish sentiment, not a bullish
market. However, an unusually high amount of short interest can lead to a short squeeze,
temporarily pushing prices up.
31. False — The odd-lot theory suggests that small investors are often wrong. Therefore, rising
odd-lot trades typically signal a market top, not a buy opportunity.
32. True — Technical analysis is largely mechanical and rule-based. Analysts use set patterns,
indicators, and historical data to make trading decisions, often with little regard for company
fundamentals.
33. True — Research shows that the consensus advice from investment newsletters often
performs poorly. Contrarian investors sometimes achieve better results by doing the opposite of
widely recommended actions.
34. False — An oversold market is generally considered undervalued, not overvalued. It
suggests that selling has been excessive and that a rebound may be near.
35. False — Charts are not just used to confirm past trends; they are also crucial for spotting
new, emerging trends. Technical analysts use charts proactively to anticipate future price
movements.
36. True — Charts help identify developing trends by showing price and volume patterns over
time. Recognizing these trends early can give investors a trading advantage.
37. True — The Relative Strength Index (RSI) compares a security’s recent gains to its recent
losses over a specific period. It helps identify whether a security is overbought or oversold
relative to itself.
38. True — Point-and-figure charts plot price movements without considering time intervals.
They focus solely on significant changes in price, filtering out minor fluctuations.
39. False — A simple moving average gives equal weight to all included data points. In contrast,
a weighted moving average assigns more importance to recent prices.
40. True — Both point-and-figure charts and moving averages smooth out short-term volatility.
They help investors focus on underlying trends rather than daily market noise.
41. False — The Mutual Fund Cash Ratio (MFCR) measures the cash holdings of mutual funds
relative to their total assets, not individual investors' portfolios. It is a sentiment indicator,
reflecting the level of cash that fund managers have available for investment.
42. True — The advance/decline line is a useful tool for timing both buying and selling
decisions. A rising line signals market strength, while a declining line indicates market
weakness.
