Stock Market and Market Efficiency

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Essay Questions #2
1 What is the evidence for stock returns following a normal distribution?
The stock markets are not normally distributed due to the volatile nature of the same. It is, therefore, quite difficult to have evidence for stock returns following a normal distribution, unless in the very few instances where the price and timing coincide.
2 If stock returns do not follow a normal distribution, this violates market efficiency. Why?
A normal distribution is usually a graphical representation with symmetry on both sides of the average. According to market efficiency, the prices of stocks should always be right due to the accurate information available concerning them. Stock returns, however, do not follow a normal distribution curve. This implies that the prices are wrong, and the information provided to this end is also not accurate or reliable. The stock price can only be altered by changing the available information since this will influence investors. The randomness of the available information means uncertainty in the accuracy of the stock prices and a subsequent infringement of market efficiency.
3 Robert Shiller found that there was much more volatility in stock prices than the information changes would suggest. Why is this a violation of market efficiency?
Shiller discovered that the stock market prices were more volatile than that of changes in dividends. This is quite interesting, considering that the former is the latter's foundation. The prices are usually either too high or too low, and only on a few occasions can one get the price right. In his assessment, the price is most of the time wrong, compared to the very few times when it is right. This is a clear violation of market efficiency, which contends that the price is always right.
4 Why is the 1987 stock market crash an example of market efficiency not holding? Explain.
Market efficiency is whereby the price of a given stock is in line with the available information. Therefore, market efficiency not holding occurs when the price is not a true reflection of the stock value. In 1987, there was a 23% drop in a single day in stock prices without any prior or later information regarding the same. The drop was worldwide. The prices are fluctuating, which is not in line with the concept of market efficiency since there was no available public information about it; hence, the market efficiency is not holding.
5 Let's play the following game: Guess a number from 0 to 100 with the goal of making your guess as close as possible to two-thirds of the average guess of those participating in the contest. Now let's assume everyone in the game is completely rational. What number will everyone choose? Why? Explain.
In this scenario, the general assumption is that everyone is rational. There are various levels of thinkers in this case. There is the first level, second, third, all the way to the n-th thinker. The number to be chosen will eventually keep going down and tend towards zero. For example, the average will first be (0+100)/2, which gives 50. So:
The first-level thinker will pick 2/3 *50, which is 33.
The second-level thinker will pick 2/3 * 33, which is 22.
The third-level thinker wi...