Question

Why in an efficient market all investments have an expected NPV of zero?

If your cousin invests in the stock market and doubles her money in a single year while the market, on average, earned a return of only 15 percent. Is your cousin's performance a violation of market efficiency?

Explain the risk that often accompanies the behavioral concept of familiarity.

Answer 1

(1): In an efficient market all investments have an expected NPV of zero because information is impounded in prices and hence investors will be expected to earn a normal rate of return. It should be noted an efficient market is one in which investors will be expected to earn only a rate of return that will be just enough to compensate for the risk borne by the investor. The difference between actual price and expected price will also be zero.

(2): Yes, your cousin’s performance is a violation of market efficiency. This is because market efficiency is earmarked by the degree to which market prices reflect all available, relevant information. In other words if the market is efficient then all information is (and should be) incorporated into stock prices and so beating the market is not possible. As current prices reflect all available and relevant information the possibility of beating the market does not exist in an efficient market.

(3): The risk that often accompanies the behavioral concept of familiarity is the risk of building a sub-optimal portfolio and the risk of ignoring other viable options that can be added to portfolio diversification. It should be noted that familiarity bias can occur when an investor has a preference for a familiar investment. This is despite the fact that there are other viable investment options available.