Question1.8 Proponents of the Efficient Market Hypothesis typically advocate ________: researching individual stocks extensively before we invest in them. security selection over asset allocation. an active trading strategy. an active trading strategy and investing in an index fund. investing in an index fund and a passive investment strategy. ResetMaximum marks: 2.5 Flag question undefined

Question

BlackTom AI · Accepted Answer

Efficient Market Hypothesis (EMH) states that asset prices fully reflect available information, so consistent excess returns through stock picking or timing are unlikely.

1. Relevant knowledge points and concepts
- EMH (weak, semi-strong, strong): prices incorporate past prices, public information, and (in the strong form) all information.  
- Implication: abnormal returns net of costs are unlikely to persist for active managers.  
- Practical consequence: favor low-cost, passive exposure (index funds) and broad asset allocation rather than frequent trading or stock-picking.

2. Step-by-step reasoning
- If markets quickly and accurately incorporate information, then researching stocks or trading frequently cannot reliably extract extra returns once costs are included.  
- Therefore proponents advocate reducing trading and management costs and holding broadly diversified market portfolios (index funds) that capture market returns.

3. Numerical illustration (intermediate steps shown)
- Assume gross market return = 8.0%.  
- Passive index fund expense = 0.10% → investor net = 8.0% − 0.10% = 7.90%.  
- Typical active manager average fee + trading costs ≈ 1.5% + 0.5% = 2.0% → investor net = 8.0% − 2.0% = 6.0%.  
- Active manager must beat the market by >2.0% before costs just to match the passive net return; evidence shows only a small fraction do so consistently.

4. Why the correct answer is correct
- Because EMH implies most active strategies won’t reliably outperform the market after costs, proponents recommend passive investing via index funds and a buy-and-hold strategy.

5. Why the other options are incorrect
- Researching individual stocks extensively: inconsistent with EMH belief that public information is already priced.  
- Security selection over asset allocation: EMH-aligned advice emphasizes asset allocation as primary return/risk driver.  
- An active trading strategy: contradicts EMH’s skepticism of consistent outperformance.  
- An active trading strategy and investing in an index fund: internally inconsistent—EMH proponents favor passive, not active, approaches.

6. Conclusion
The correct answer is "investing in an index fund and a passive investment strategy," which matches the provided answer.

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