Question

Mr April has been left 30,000 € which he plans to invest on the Stock Exchange in order to have a source of capital should he decide to start his own business in a few years’ time. A friend of his who works in the City of London has told him that the London Stock Exchange shows strong form market efficiency.

If this is the case, which of the following investment strategies should Mr April follow?

Select one:

a. Study the company reports in the press and try to spot under-valued shares in which to invest.

b. Invest in two or three blue chip companies and hold the shares for as long as possible

c. Build up a good spread of shares in different industry sectors

d. Study the company reports in press and try to spot strongly growing companies in which to invest

Answer 1

The given case is based on the theory of Efficient Market Hypothesis (EMH), which states there can be 3 forms of market efficiency - strong, semi-strong and weak. In the given case, London stock exchange shows a strong form of market efficiency.This means all the information , both Public and Private are available to all investors and hence they are already factored in the stock's price.

Thus the answer here is option c. Build up a good spread of shares in different industry sectors. This will lead to diversification benefits and hence lead to risk reduction. As the industry performs good, portfolio will perform good.

Option a & d are about Study the company reports in the press and try to spot under-valued shares/strongly growing companies in which to invest. There are incorrect investment strategy in strongly efficient market as all public and private information are already included in stock price. So any kind of company reports study available in press (i.e. Public Information) won't help to gain value.

Option b is about Invest in two or three blue chip companies and hold the shares for as long as possible. This is again incorrect as blue chip companies are those that are fundammentally strong. Since market is strongly efficient, company's fundamentals will be available to public and hence already factored in stock price.