Advanced Diploma of Financial Planning (ADFP) Practice Test

Which statement is true regarding the assumptions behind passive investment strategies?

1. They believe the market is inefficient.

2. They believe the market is efficient.

3. They entirely reject the concept of risk.

4. They do not consider transaction fees.

The correct answer is: They believe the market is efficient.

Passive investment strategies are grounded in the belief that markets are efficient, meaning that asset prices reflect all available information at any point in time. This efficiency suggests that it is difficult for investors to consistently achieve returns that exceed the average market return, making it unnecessary for them to attempt to time the market or pick individual stocks. Instead, passive investors typically focus on broad market indices and hold a diversified portfolio, taking advantage of the overall market return over the long term. This approach contrasts with active strategies, which operate under the assumption that markets are inefficient and that certain opportunities can be exploited for higher returns. Additionally, while passive investors acknowledge the presence of risk, they embrace a long-term investment horizon that accounts for market fluctuations rather than trying to avoid risk altogether. Regarding transaction fees, while they are certainly a factor in investment strategies, passive approaches generally aim to minimize these fees by reducing trades and maintaining a longer-term investment perspective. Thus, the assertion that the market is efficient is central to the philosophy of passive investment strategies.