Stock Trading Research & Evidence-Based Practice 3 — Questions and Answers
Question 1: Which of the following best describes the Efficient Market Hypothesis (EMH) in its strong form?
- Prices reflect only publicly available information
- Prices reflect all public and private (insider) information (Correct answer)
- Prices react slowly to new information
- Technical analysis can consistently beat the market
Correct answer: Prices reflect all public and private (insider) information
The strong form of EMH asserts that stock prices already incorporate all information, including insider knowledge, making it impossible to consistently earn excess returns.
Question 2: A trader finds that a momentum strategy generated 18% annual returns in backtest but only 6% in live trading. This discrepancy is most likely due to:
- Improved market conditions after the backtest period
- Overfitting the strategy to historical data (Correct answer)
- An error in the brokerage's reporting system
- The strategy being too conservative
Correct answer: Overfitting the strategy to historical data
When backtest performance greatly exceeds live performance, the strategy was likely overfit to historical data and does not generalize to new market conditions.
Question 3: Which metric measures the largest peak-to-trough decline in a portfolio's value during a specific period?
- Standard deviation
- Beta
- Maximum drawdown (Correct answer)
- Sortino ratio
Correct answer: Maximum drawdown
Maximum drawdown quantifies the worst loss from a portfolio's peak to its subsequent trough, reflecting downside risk during the measurement period.
Question 4: What does the Fama-French three-factor model add to the traditional CAPM model?
- Momentum and reversal factors
- Size and value factors (Correct answer)
- Liquidity and leverage factors
- Sentiment and earnings factors
Correct answer: Size and value factors
The Fama-French model extends CAPM by adding small-cap size (SMB) and high book-to-market value (HML) factors to better explain cross-sectional stock returns.
Question 5: When evaluating a stock research report, which element most indicates potential bias?
- Inclusion of financial ratios and valuation models
- Disclosure that the analyst's firm holds shares in the rated company (Correct answer)
- Use of historical earnings data
- Citation of SEC filings as a primary source
Correct answer: Disclosure that the analyst's firm holds shares in the rated company
A conflict of interest disclosure — such as the analyst's firm holding the stock — is a key red flag for potential bias in a research report.
Question 6: Which practice helps prevent survivorship bias when researching historical mutual fund performance?
- Focusing only on funds with 10+ year track records
- Including data from funds that have since been merged or liquidated (Correct answer)
- Using only funds rated 4 or 5 stars by Morningstar
- Excluding funds that changed their investment mandate
Correct answer: Including data from funds that have since been merged or liquidated
Survivorship bias occurs when only existing (surviving) funds are studied; including defunct funds provides a realistic picture of historical performance distribution.
Question 7: What is the primary purpose of a Monte Carlo simulation in trading research?
- To predict exact future stock prices
- To model the range of possible outcomes by running thousands of random scenarios (Correct answer)
- To identify insider trading patterns
- To calculate a company's intrinsic value
Correct answer: To model the range of possible outcomes by running thousands of random scenarios
Monte Carlo simulations run thousands of randomized scenarios to estimate the probability distribution of outcomes, helping traders understand the range of possible results.
Stock Trading Research & Evidence-Based Practice 3
Which of the following best describes the Efficient Market Hypothesis (EMH) in its strong form?