Question

A) In a semi strong form market, how would stock prices react to a company announcing yearly profits?

B) Martha can make abnormal returns trading on information - what does this say about the efficiency of the market? Give 2 reasons why she shouldn't do this.

C) Your friend wants to invest all of his wealth into stocks due to a pick from a technical analysis. Discuss why he is an idiot for doing that ensuring you talk about market efficiency and diversification.

Answer 1

Answer

1) The abnormal returns amount to Speculative Gains. It means that the market is less efficient and needs more stringent regulations and governance. It also means that there are good number of speculators in the market and there could be frauds brewing.

Two reasons why Martha should not indulge in speculation are -

a) Speculative gain and losses are like the outcome of a roulette wheel and random without a logic. Chances of a net short position is common in most speculators.

b) Martha could get barred from trading and also face legal action for 'Insider Trading'.

2) Putting all the money in one stock based on one technical analysis (could be often incorrect) or in common parlance "putting all the eggs in one basket" could risk losing all the investment if the stock goes down. Following are advises that can be given to your friend about advantages of a diversified portfolio -

a) Diversification is a hallmark of Modern Portfolio theories lowering portfolio volatility, increasing risk-adjusted returns, and reducing dependence on any one company, sector, market etc.

b) Potential of earning a 'diversification premium'. This is usually earned for careful investments in diversified portfolio over risk free return instruments, held over a period of time.