Certified Financial Management Specialist Practice Exam

Which theory states that stock prices efficiently reflect all available information?

1. Behavioral Finance Theory

2. Efficient Market Hypothesis (EMH)

3. Capital Asset Pricing Model (CAPM)

4. Modern Portfolio Theory

The correct answer is: Efficient Market Hypothesis (EMH)

The Efficient Market Hypothesis (EMH) is the theory that states stock prices efficiently reflect all available information. According to this hypothesis, it is impossible for investors to consistently achieve returns that exceed average market returns on a risk-adjusted basis, since stock prices already incorporate and reflect all known information. This means that any new information that becomes available is quickly reflected in the stock price, which leads to fair pricing based on the current market situation. The EMH is widely discussed in finance as it implies that the market is rational and that investment strategies aiming to outperform the market through stock selection or market timing are unlikely to succeed, as all available information is already accounted for in stock prices. This theory is influential in guiding investment strategies, as it suggests that passive investment approaches, such as index fund investing, may often be more effective than active management. Other theories mentioned serve different purposes in financial theory. Behavioral Finance focuses on the psychological influences on investor behavior and how those can lead to market inefficiencies. The Capital Asset Pricing Model (CAPM) helps in determining return expectations based on risk, while Modern Portfolio Theory explains how to construct an investment portfolio to maximize returns for a given level of risk. However, none of these theories specifically addresses the idea of market efficiency