Advanced Diploma of Financial Planning (ADFP) Practice Test

What is a key characteristic of a passive investment strategy in terms of market efficiency?

1. It assumes superior market analytical skills.

2. It accepts the market price as the best estimate of security value.

3. It relies heavily on stock picking.

4. It encourages frequent trading.

The correct answer is: It accepts the market price as the best estimate of security value.

A passive investment strategy is fundamentally rooted in the belief that markets are generally efficient, meaning that all available information is already reflected in the current prices of securities. By accepting the market price as the best estimate of the intrinsic value of an asset, passive investors typically avoid trying to outperform the market through frequent trading or detailed stock picking. This approach is based on the understanding that trying to time the market or select individual stocks often leads to higher costs and variable performance. In contrast, strategies that assume superior market analytical skills or encourage frequent trading are more aligned with active management approaches, which aim to capitalize on perceived market inefficiencies. Reliance on stock picking also conflicts with the essence of passive investing, which typically involves a diversified portfolio that mirrors a market index rather than attempting to select individual stocks based on analytical skills. Therefore, the acceptance of the market price as a reliable estimate of security value is a defining characteristic of passive investing.