Many managers of mutual funds proclaim that they have been able to generate consistently higher rates of return on their investments than the general stock market bu buying shares of undervalued companies. Classical economic theory, however, proposes the "efficient capital markets hypothesis", which proposes that stock prices accurately reflect the value of the underlying investments, incorporating all information available to the public. if the efficient capital markets hypothesis is correct, then it should be expected that_____________.

A) mutual fund managers, in order to compete with each other, will bid up the prices of certain stocks beyond their true values

B) mutual fund managers use insider information, an illegal practice, to generate higher rates of return than the general stock market

C) stock price will rise over time

D) given public information alone, companies cannot reliably be labeled undervalued or overvalued relative to to the general stock market

E) some mutual fund managers are better than others at generating a higher rate of return on investments

I do not understand the official explanations for answers C and D.
If the efficient capital markets hypothesis is correct, why stock prices will not rise over time?
Who do you analyze if D is correct or not? I do not understand the reasoning.
thanks

Classical economic theory suggests that stock prices reflect all publicly available information. However, not all relevant information is publicly known, or else stocks would never be mispriced. D seems to follow

Premise: fund managers claim that they generate higher rates of return on their investments than the general stock market by buying shares of undervalued companies. Paraphrase: fund managers say they buy stock that is priced below its true value--they think they know something the market does not.

Premise: efficient markets hypothesis = stock prices accurately reflect the value of the underlying investments, incorporating all information available to the public.

Draw a conclusion = "Which answer choice can you PROVE with the premises?"

C) stock prices will rise over time.

We cannot PROVE this. The fund managers think that the stocks they pick will rise in value, but there is no proof that they are correct. Furthermore, this choice refers to "stock prices" in general. There is nothing in the argument that indicates that stocks can't fall in value.

D) given public information alone, companies cannot reliably be labeled undervalued or overvalued relative to to the general stock market

"Undervalued," to the fund managers in the premise, means that a stock/company is actually worth more than the market price. But the efficient markets hypothesis (which we are told to consider correct when drawing our conclusion), says that the price of a stock = the actual value of the stock, based on public information.

You asked how to evaluate choice D: the best way is to note how similar it is to the 2nd premise.

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Emily Sledge
Instructor
ManhattanGMAT

In Option A, True value is misleading. How do you know true value is not based on classical economic theory? Also, how do you know whether the prices of stocks of underlying companies will bid up as a result of buying of shares by Mutual Fund. Mutual Fund Managers makes higher rate of return on their investment. The time frames of higher rate of retun can be one year and within that one year, price of the stock might go up as well as down. Not just up as stated in Option A.

I think A has fallacies.

Hi Ashish,
Your questions seem to be rhetorical--do you have a question about choice A?

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Jamie Nelson
ManhattanGMAT Instructor