Question
S1: In the 1960s, Eugene Fama began shaping his ideas regarding what he would later term the “Efficient Market Theory.” S2: According to the Efficient Market Theory, which holds that the price movements of financial assets cannot be predicted because the prices of these assets fully reflect all available information, the prices of financial assets are rationally determined by investors. S3: Consequently, this model does not allow for the existence of asset bubbles, which are, by definition, situations that result from irrational increases in asset prices to levels well above any justified by economic fundamentals.
S4: On the other hand, Robert Shiller, whose work focuses on the integration of behavioral models into economic models, sees the pricing of financial assets as irrational, sometimes incredibly so, and argues that the predictability of prices is a reflection of irrational but repeating patterns of human behavior. S5: In his 1989 book Market Volatility, Shiller wrote that the idea that stock prices were rational was “one of the most remarkable errors in the history of economic thought.” S6: Shiller sees financial asset bubbles as a natural consequence of irrational human behavior, and as a result believes that markets can and do create large, sustained mispricings. S7: Perhaps this line of reasoning is what enabled him to predict the sharp decline in stock prices in 2000 and the housing crash that began in 2006.
Which of the following is mentioned in the passage as a reason why the price movements of financial assets are considered unpredictable under the Efficient Market theory?
The prices of financial assets are more rationally determined than those of any other assets.
Any information that is available is reflected in the prices of financial assets.
Prices of financial assets often depart from levels justified by economic fundamentals.
Financial markets are more efficient than they were in the past.
Markets are too irrational for there to be any patterns to the movements of prices of financial assets.
Question
S1: In the 1960s, Eugene Fama began shaping his ideas regarding what he would later term the “Efficient Market Theory.” S2: According to the Efficient Market Theory, which holds that the price movements of financial assets cannot be predicted because the prices of these assets fully reflect all available information, the prices of financial assets are rationally determined by investors. S3: Consequently, this model does not allow for the existence of asset bubbles, which are, by definition, situations that result from irrational increases in asset prices to levels well above any justified by economic fundamentals.
S4: On the other hand, Robert Shiller, whose work focuses on the integration of behavioral models into economic models, sees the pricing of financial assets as irrational, sometimes incredibly so, and argues that the predictability of prices is a reflection of irrational but repeating patterns of human behavior. S5: In his 1989 book Market Volatility, Shiller wrote that the idea that stock prices were rational was “one of the most remarkable errors in the history of economic thought.” S6: Shiller sees financial asset bubbles as a natural consequence of irrational human behavior, and as a result believes that markets can and do create large, sustained mispricings. S7: Perhaps this line of reasoning is what enabled him to predict the sharp decline in stock prices in 2000 and the housing crash that began in 2006.
Which of the following is mentioned in the passage as a reason why the price movements of financial assets are considered unpredictable under the Efficient Market theory?
The prices of financial assets are more rationally determined than those of any other assets.
Any information that is available is reflected in the prices of financial assets.
Prices of financial assets often depart from levels justified by economic fundamentals.
Financial markets are more efficient than they were in the past.
Markets are too irrational for there to be any patterns to the movements of prices of financial assets.
Text Solution:
(Note: This explanation mentions sentence numbers, S1, S2, and so on. You can display these sentence numbers in the passage by clicking on the Sentence Numbering switch above the passage.)
Reading the question stem, we see that the focus of this question is “a reason why the price movements of financial assets are considered unpredictable under the Efficient Market theory.”
So, to find the information we need for answering the question, we’ll go to the area of the passage where we saw the “Efficient Market Theory” discussed as we read the passage, which is the 1st paragraph.
Then, we can go through the answer choices and carefully compare each with what the 1st paragraph says about the “Efficient Market Theory” until we have eliminated the choices that are not supported by the passage and found one that is.
(A) The prices of financial assets are more rationally determined than those of any other assets.
Notice that the passage does not support what this choice says.
S2 says, “According to the Efficient Market Theory … the prices of financial assets are rationally determined by investors.” However, it does not compare the prices of financial assets with the prices of other assets by saying that the prices of financial assets are “more rationally determined than those of any other assets.”
CORRECT ANSWER(B) Any information that is available is reflected in the prices of financial assets.
Notice that, “any information” in this choice means basically the same thing as “all available information” in S2 of the passage. So, this choice restates what S2 says about the reason why financial asset prices are considered unpredictable under the Efficient Market Theory: “the Efficient Market Theory, which holds that the price movements of financial assets cannot be predicted because the prices of these assets fully reflect all available information.”
So, this choice matches what the passage mentions as the reason why the price movements of financial assets are considered unpredictable under the Efficient Market theory.
(C) Prices of financial assets often depart from levels justified by economic fundamentals.
This choice could be tempting because it uses wording, “levels justified by economic fundamentals,” that matches wording found in S3 of the passage and because it seems logical that prices’ departing from levels justified by economic fundamentals would cause them to be unpredictable.
However, this choice is incorrect because it’s not supported by what the passage says. After all, the passage simply does not say that, according to the Efficient Market Theory, prices of financial assets are unpredictable because they often depart from levels justified by economic fundamentals.
The passage mentions “the Efficient Market Theory” and price “levels well above any justified by economic fundamentals” but does not connect them in the way this choice does.
(D) Financial markets are more efficient than they were in the past.
The passage mentions various dates in the past: the 1960s, 1989, 2000, and 2006. The passage also discusses Efficient Market Theory.
However, the passage never actually compares the efficiency of markets in past and current markets.
The passage does compare Fama's view that asset prices are rationally determined — that is, the Efficient Market Theory — with Shiller's view that asset pricing is irrational.
Of course, ideas about the market that were conceived in different time periods are not the same as actual market efficiency during different time periods.
So, the passage does not support what this choice says.
(E) Markets are too irrational for there to be any patterns to the movements of prices of financial assets.
Notice that S2 says, “According to the Efficient Market Theory … the prices of financial assets are rationally determined by investors.” So, what this choice says, “Markets are too irrational,” is the opposite of how markets are described under the Efficient Market Theory.
Furthermore, S4 says, “the predictability of prices is a reflection of irrational but repeating patterns of human behavior.” So, if anything, the passage associates markets being irrational with prices being predictable, not with prices being unpredictable.
