Chapter 9

Differentiating itself from traditional financial fields, behavioral finance uniquely relies on what field of study to help develop its theories of behavior?

psychology

If behavioralists are correct about limits to arbitrage activity, then the absence of profit opportunities does not necessarily imply that markets are

efficient

An investor purchases shares in Egg Company because it has announced a large increase in current earnings. The investor is aware that Egg has a history of generating poor earnings for several periods after large increases but feels this time is different. This investor is exhibiting signs of:

error in forecasting Reason: Forecasting errors are the result of placing too much emphasis on recent events while ignoring historical events.

Demonstrating the pervasiveness of overconfidence, despite strong evidence to active management under-performance, indexing accounts for what percentage of the overall equity held in the mutual fund industry?

25%

Dawn Hill is a technical analyst who searches for momentum in asset prices. Hill believes Green Tech, which has experienced a 4% increase over the last three days is poised for even more price appreciation. Hill most likely is using which type of momentum strategy?

Absolute Reason: Absolute momentum refers to finding individual securities that are likely to increase in value after having experienced a price gain already.

Patrick Dill is a technical analyst who trades based on historical price movements together with company announcements. Today, Dill buys shares in Blue Golf Company which announced last week that it was expanding into Mexico. Dill most likely believes:

Blue Golf shares respond gradually to the announcement Reason: Technical analysts believe that investors cannot rapidly process the full information value of a corporate event and the result is that prices adjust slowly.

True or false: Framing can increase the effects of regret avoidance.

False Reason: Mental accounting adds to regret avoidance because investors focus on individual security performance rather than portfolio performance.

John King is saving for a new house he wants to build in two years and has invested in what he believes is an undervalued financial asset. King believes the asset will double in value. Which of the following limitations might prevent King from achieving his goal?

Fundamental risk Reason: The asset might in fact double in value, but it might take longer than King's two year time horizon. This is fundamental risk.

What are the two generally accepted irrational behavior categories that behavioral finance observers?

Investors do not always process information correctly and have incorrect probability distributions about future rates of returns. Investors make inconsistent or systematically suboptimal decisions.

Ellen Ways exhibits behavior consistent with prospect theory. Which of the following would characterize the risk attitude of Ways?

She is loss averse. Reason: Aversion to losses drives decision making in prospect theory.

Fundamental risk affects closed end funds in which of the following ways?

The fund can sell at a discount and the discount could increase Reason: The discount on a mutual fund should approach the NAV of the fund, but some times the discount increases, reflecting fundamental risk.

The insights of behavioral finance may lead to some of the same policy conclusions embraced by efficient market advocates.

True

A financial analyst is hoping to determine which market has the stronger rally by comparing advances and declines. The US market in the farming sector has 21 advances and 6 declines, while the Canadian market has 9 advances to 7 declines. Which market is the analyst more likely to identify as being stronger?

US market Reason: The US market has 15 more advances than declines while the Canadian market has only 2 more. The US market should be considered to have the stronger rally.

Wilson Fund is a closed end mutual fund that sells at a discount from its NAV. The most likely reason for this discount is:

Wilson has more volatility due to the specific composition of its portfolio Reason: Discounts and premiums tend to be higher in those funds with more idiosyncratic risk.

A financial analyst observes the price of Red Line Company shares seems to be consistently $1.00 to $2.00 higher than its intrinsic value. This distortion is most likely to cause:

a misallocation of capital market resources to Red Line and away from its competition Reason: Distorted prices can easily cause the markets to supply capital to an overvalued firm, with less capital going to undervalued firms.

Distorted prices in the capital markets give misleading signals as to the way in which an economy may best _____ resources.

allocate

The main reason that investors should be aware of behavioral issues in portfolio management is to:

avoid making information processing errors Reason: An understanding of behavioral problems can lead to a more efficient set of decisions for investors.

A trin stat that is considered bullish would

be less than 1.

Use of the confidence index is based on the assumption that the ______ provides information about future equity returns.

bond market Reason: Users of the confidence index assume that a low price of risk in the bond market will extend to equity markets.

Jon Grimm is a technician who has observed an increase in the put call ratio. Grimm is likely to view this change as an indication that markets will:

fall Reason: Technicians view increases in the ratio as a hedge against market declines.

The tendency for investors to too slowly update their beliefs in response to new evidence is called

conservatism bias.

Fill in the blanks to complete the sentence. Contrarian investors belive it is a good time to sell when there is a _____ in the put/call ratio.

decrease

An investor decides to purchase shares of stock in a firm based solely on the fact that the firm bought the naming rights to a new professional stadium located right near the investor's home. This irrational decision is most likely attributed to:

faulty information Reason: Buying shares of stock for personal reasons and not fundamental reasons is an example of processing information incorrectly.

A decision that is affected by how the choices are presented is said to be subject to

framing

Jack and Martha watch two different weather stations before departing for work. One station reports a 50% chance of rain and Jack takes his umbrella to work. The other station reports a 50% chance of no rain and Martha leaves her umbrella at home. The difference decisions made by Jack and Martha can be attributed to:

framing Reason: Decisions are affected by the manner in which the question is framed.

The potential risk that a mispriced security takes too long to converge to intrinsic value is known as

fundamental risk

Prospect Theory states that investor utility is most dependent on

gains or losses from the investor's starting position

One critical component of behavioral finance is the belief that arbitrageurs:

have limited ability to push prices back to their intrinsic values Reason: Behavioral finance models suggest investors cannot possibly find all the arbitrage opportunities in capital markets and consequently, prices can move away from their fundamental values.

An analyst observes the ratio of AA rated bond yields to B rated bond yields to be 95%, which is an indication of:

high confidence Reason: When this ratio approaches 100%, the confidence in the bond market is likely to spill over in the equity market.

Behavioral finance is based on the assumption that some investors are:

irrational Reason: Research suggests that the market anomalies and irrationalities are caused by the existence of irrational investors.

Forecasting is often times made with error because investors suffer from:

memory bias Reason: Investors give too much weight to recent experiences and it affects their ability to forecast without bias.

Ron Oort invests in a high risk financial asset to help him achieve his goal of buying a speed boat in five years. This asset is much riskier than his retirement portfolio. This is an example of:

mental accounting Reason: Mental accounting involves having separate accounts, some with different risk characteristics.

Rachel Wills is a high net worth investor who has different accounts for different objectives. Wills has an account for her daughter's education, an account for annual summer vacations, and an account for for annual trip to gamble in Las Vegas. Wills most likely suffers from:

mental accounting Reason: Mental accounting occurs when an individual has different risk tolerances for different accounts.

One risk faced by investors is _____ risk, where an apparent profit opportunity is more apparent than real.

model

Pete Link uses historical returns and regression analysis to locate under valued stocks. Link buys share in any company in which a specific regression parameter is less than 1.0. The most likely reason Link might not earn superior returns is:

model risk Reason: Modeling error can result in faulty predictions because the model does not capture all the risk inherent in an investment.

Suppose a market exists in which investors suffer from conservatism. The most likely divergence from traditional capital market theory would be:

momentum in stock prices Reason: Because conservatism suggests that investors tend to under react to new information, it is likely that there is only a gradual change in stock prices over time to their intrinsic values.

John Ink is an active investor who has never purchased an indexed mutual fund. Ink's investing behavior is most likely due to:

overconfidence Reason: Most active investors are overconfident in their ability to make investment decisions.

Technical analysis attempt to exploit _____ in stock prices to generate superior investment performance.

patterns

Bill Hatts is a technical analyst who uses the price of individual securities and an index of securities in specific sectors to identify undervalued securities. If Hatts computes a ratio of those two numbers, he is most likely using:

relative strength Reason: Relative strength analysis would compute the ratio of share price to index value to determine whether the stock should outperform or under perform the index.

The moving average share price of Potts Electric has shifted from being higher than the share price to being lower. A technical analyst would most likely view this as a sign of ______ stock prices.

rising Reason: This trend signifies a bullish market.

Jan Peck is a technical analyst who firmly believes in momentum. Peck is likely to view a specific stock as being overvalued when:

the moving average is higher than the current stock price Reason: When moving averages exceed stock prices, there will be more selling in the market so the price reverts to its more normal level.

The trin statistic is

the ratio of average trading volume in declining issues to average volume in advancing issues.

According to De Bondt and Thaler (1987) regret avoidance is consistent with both

the size effect the book-to-market effect