Chapter 14: Behavior Finance Aplication

Diversification

Spreading out investments to reduce risk

Shanelle sees that a fund that has a long track record of success has had a recent run of underperformance. She chooses not to invest in the fund because she has a feeling that the underperformance is bound to continue. Which heuristic or bias is affecting her decision? (A) Hot hand fallacy (B) Anchoring (C) Overconfidence (D) Availability

(A). The hot hand fallacy is the assumption that a losing streak will continue as any trend is bound to continue. The longer the losing streak, the stronger the effect of the hot hand fallacy. (B), (C), and (D) are not correct heurtistics.

All of the following comments apply to the importance of advisors understanding the concepts of behavioral finance EXCEPT: (A) Knowledge of behavioral finance involves ethical considerations. (B) Investment return is the same as investor return. (C) Markets tend to be inefficient, based in part on investor sentiment and momentum. (D) The decision errors of individuals have an effect on market movement.

(B). Investment return is rarely the same as investor return.

Why do investors hold inefficient portfolios? I. The stockholding puzzle suggests that people over-invest in risky stocks. II. Inertia and emotional attachment based on the endowment effect. (A) I only (B) II only (C) Both I and II (D) Neither I nor II

(B). The stockholding puzzle actually refers to why so few Americans own stocks.

Fama and French did research that concluded: I. There is no evidence that stock managers are able to persistently beat the market. II. Value exchange-traded funds (ETFs) can match the performance of skilled active managers due to market inefficiencies, according to research in behavioral finance. (A) I only (B) II only (C) Both I and II (D) Neither I nor II

(C). Both statements are correct based on Fama and French research.

Nobel prize-winning economist Robert Schiller's "volatility puzzle" I. suggested stock prices move far more than they should based on earnings and interest rate variations II. disputed efficient market theorems (A) I only (B) II only (C) Both I and II (D) Neither I nor II

(C). Both statements are true. Excess stock volatility is based on investor sentiment and momentum. Investor sentiment refers to beliefs about future risks and cash flows that are not necessarily justified by viable information.

Lupita made her first mutual fund investment in a technology mutual fund in 1999. She lost more than half of her investment during the market correction of 2000. Lupita has since been convinced that technology mutual funds are too risky for any part of her investment portfolio. The scenario above is an example of which decision-making bias or heuristic? (A) framing (B) confidence (C) anchoring and adjustment (D) endowment effect

(C). Lupita "anchored" her perception of technology investing to a severe market correction. She then failed to "adjust" her perception of technology investing to her current situation. (A), (B), and (D) apply to other behavioral finance biases and heuristics.

All of the following are market anomalies in the context of behavioral finance EXCEPT: (A) Low volatility anomaly (B) Value effect (C) Periodic rebalancing (D) Small-stock effect

(C). Periodic rebalancing helps clients move stocks that have recently risen in value into safer assets such as bonds and encourages clients to buy more stocks after prices have fallen to maintain a desired allocation. It is not a market anomaly. Answers( A), (B), and (D) are market anomalies in the context of behavioral finance.

Bill is a day trader who owns a stock that has shown positive market movement in each of the last 20 trading sessions. Independent of any information on the stock, Bill chooses to buy the stock at the end of the 20th trading day, believing that the stock should continue to go up based on its current momentum. Which bias/heuristic affected Bill's decision? (A) overconfidence (B) availability (C) satisficing (D) hot hand fallacy

(D). The hot hand fallacy is demonstrated when a person predicts the outcome of random future events based on a previous event or series. In this case, the trader believes the stock is "on a positive run" and should continue to outperform. The daily return of a stock is not associated with the return of the stock on a previous day or series of days. It is similar to flipping a coin. Each flip is an independent event. (A), (B), and (C) apply to different behavioral finance biases and heuristics.

Modern Portfolio Theory (MPT)

A method of choosing investments that focuses on the importance of the relationships among all of the investments in a portfolio rather than the individual merits of each investment. The method allows investors to quantify and control the amount of risk they accept and return they achieve.

Capital Asset Pricing Model (CAPM)

A model that relates the required rate of return on a security to its systematic risk as measured by beta

Unsystematic risk

A risk that affects at most a small number of assets. Also, unique or asset-specific risk

Stockholding Puzzle

All investors should own stock but about 2/3 of american's dont own any (even if they are risk averse)

3 Factor Model

An asset pricing model that expands on the capital asset pricing model (CAPM) by adding size risk and value risk factors to the market risk factor in CAPM. This model considers the fact that value and small-cap stocks outperform markets on a regular basis.

Confirmation Bias

An investor forms a set of beliefs, she will pay greater attention to information that confirms these beliefs (and will tend to ignore information that counters her opinions)

Mutual Fund Theorem

An optimal investor portfolio in an MPT world would consist of only two financial assets - a risk-free investment and a market portfolio

Mean Reversion

Assumption that a stock's price will tend to move to the average price over time

Risk Premium

Compensation for taking greater investment risk

By adding more stocks to the portfolio an investor is not able to lower their risk and expected return will not be effected.

False. Diversification in the portfolio reduces risk and holding a smaller number of stocks subjects the investor to higher risk without extra return. This is why under-diversification is inefficient.

Investor return typically matches average investment return.

False. Investor return is typically lower than investment return. Behavioral finance, in part, is the study of the decision errors that result in investor return being lower than market return.

Active portfolio management generally outperforms passive investing.

False. It is possible to invest in passively managed small cap and value ETFs and mutual funds with low fees that match the performance of skilled active managers.

Markowitz's modern portfolio theory (MPT) created a framework for understanding how financial risk fits into behavioral finance.

False. MPT created a framework for understanding how financial risk fit into neoclassical economics.

According to EMH, stocks never trade at fair market value and it is therefore possible to outperform.

False. The theory holds that stocks always trade at their fair market value, rendering it impossible for investors to outperform the overall market without purchasing riskier (higher beta) investments.

High beta stocks offer the highest return according to Baker, Bradley and Wurgler's 2011 paper.

False. Their research showed that the lower beta stocks outperformed.

Weak Form

Historical price and volume data are incorporated into the current price of a stock

Strong Form

Incorporate all public and private information into asset prices

Availability Heuristic

Individuals tend to judge the probabilities of decisions (such as investing in stocks) using easily available information held in one's memory

Overconfidence Bias

Investors believe that they are skilled at selecting stocks, just as they are better than average drivers and have a better sense of humor

Overraction

Investors that have too large of a reaction to new information

Divergence of Opinion

Mispricing of stock Small stocks and stocks that have no track record of past earnings are particularly vulnerable to mispricing because of a divergence of opinion because those with the most optimistic estimates of growth possibilities will be bidding on shares of the stock

Momentum Effect

Occurs when yesterday's winner is more likely to outperform in the near future and has been documented in the finance literature

Alpha

Performance above what would be predicted by CAPM is known as Jensen's alpha

Semi Strong Form

Public info cannot be used to beat the market. Prices reflect all security market information and other public information (dividend announcements, ratios). Investors can earn an excess return through the use of non public information

System Risk

Risk that cannot be diversified away

Small Stock Effect

Smaller firms, or those companies with a small market capitalization, outperform larger companies. ... At times, the small firm effect is used as rationale for the higher fees that are often charged by fund companies for small cap funds.

Limit to Arbitrage

Sophisticated traders are often restricted in their ability to correct stock mispricing. Any factor that impacts a rational trader's ability to force down the price of an overpriced stock

Recency Bias

Stock market participants evaluate their portfolio performance based on recent results or on their perspective of recent results and make incorrect conclusions that ultimately lead to incorrect decisions about how the stock market behaves.

Low Volatility Anomaly

Stocks with greater price volatility ave lower returns, and stocks that are less volatile have higher returns High Alpha Low Beta

Value Effect

Tendency of value stocks to outperform the market in the long term. A number of explanations have been suggested for the value effect. These include. It is a compensation for risk. It is a genuine effect, but can be explained by Q-theory.

Home Bias

Tendency to overweight investments in one's own geographical region

Return Chasing

The act or practice of taking on more (or excessive) risk in hopes of generating larger gains. For example, an investor who overexposes his portfolio to a security that happens to be bullish is said to be chasing returns.

Hot Hand Fallacy

The purported phenomenon that a person who experiences a successful outcome with a random event has a greater probability of success in further attempts

Risk Tolerance

The ratio of each asset (Risk Free and Market Portfolio) that exist in a portfolio

Private Equity Premium Puzzle

The strong desire to hold private business assets as a private equity premium puzzle because these private business assets are so much riskier than a well-diversified stock portfolio without any financial rewards

Hindsight Bias

The tendency to believe, after learning an outcome, that one would have foreseen it

Efficient Market Hypothesis (EMH)

The theory holds that securities always trade at their fair market value, rendering it impossible for investors to outperform the overall market without purchasing riskier investments

Volatility Puzzle

Their prices move far more than they should. Interest rates adjust gradually and earnings don't vary that much year to year, but stock prices move

Market Portfolio

Theoretical bundle of investments that includes every type of asset available in the world financial market, with each asset weighted in proportion to its total presence in the market.

Illusion of control is related to under-diversification in a portfolio.

True

Mean reversion relies on irrationality and market sentiment.

True

Overconfidence bias causes investors to believe that they are skilled at selecting stocks.

True

The availability bias is demonstrated when people reference information that is more accessible or more intense in their memories.

True

The availability heuristic suggests that individuals tend to judge the probabilities of decisions (such as investing in stocks) using easily available information held in one's memory.

True

The core idea of CAPM is that all financial assets can be priced based on their risk, or how uncertain their payout will be in the future.

True

There is some evidence that markets fall between semi-strong and strong form efficient.

True

A phenomenon called hot hand fallacy is in effect when an investor believes high recent performance in a stock or mutual fund will likely continue into the future.

True. High recent performance often occurs in high sentiment stocks or funds that are more likely to underperform in the future.

Consumer Sentiment Index

University of Michigan's consumer sentiment appears to be correlated with the performance of the overall market