Behavioral Finance and Technical Analysis

Question 1

What is the premise of behavioral finance?

Answer 1

Conventional financial theory ignores how real people make decisions and that people make a difference.

Question 2

Which information processing anomaly does the following describe?

People tend to overestimate the precision of their beliefs or forecasts, and they tend to overestimate their abilities. The dominance of active management in the face of the typical underperformance of such strategies is consistent with a tendency to overestimate ability.

a) Conservatism
b) Overconfidence
c) Sample Size Neglect and Representativeness
d) Forecasting Errors

Answer 2

b) Overconfidence

Question 3

Which information processing anomaly does the following describe?

Investors are too slow in updating their beliefs in response to new evidence. This means that they might initially underreact to news about a firm, so that prices will fully reflect new information only gradually.

a) Conservatism
b) Overconfidence
c) Sample Size Neglect and Representativeness
d) Forecasting Errors

Answer 3

a) Conservatism

Question 4

Which information processing anomaly does the following describe?

People commonly do not take into account the size of a sample, acting as if a small sample is just as representative of a population as a large one.

a) Conservatism
b) Overconfidence
c) Sample Size Neglect and Representativeness
d) Forecasting Errors

Answer 4

c) Sample Size Neglect and Representativeness

Question 5

Which information processing anomaly does the following describe?

People give too much weight to recent experience compared to prior beliefs when making forecasts and tend to make forecasts that are to extreme given the uncertainty inherent in their information.

a) Conservatism
b) Overconfidence
c) Sample Size Neglect and Representativeness
d) Forecasting Errors

Answer 5

d) Forecasting Errors

Question 6

Which of the following describe the behavioral bias ‘affect’?

a) Decisions are affected by how choices are framed.
b) People segregate certain decisions. Ex. An investor may take a lot of risk with one investment account but establish a very conservative position with another account that is dedicated to her child’s education.
c) Psychologists have found that individuals who make decisions that turn out badly have more regret when that decision was more unconventional.
d) A feeling of ‘good’ or ‘bad’ that consumers may attach to potential purchase or investors attach to a stock.
e) Modifies the analytic description of rational risk-averse investors found in standard financial theory. Higher wealth provides higher utility, but at a diminishing rate. This gives rise to risk aversion. Utility depends on changes in wealth from current level.

Answer 6

d) A feeling of ‘good’ or ‘bad’ that consumers may attach to potential purchase or investors attach to a stock.

Question 7

Which of the following describe the behavioral bias ‘prospect theory’?

a) Decisions are affected by how choices are framed.
b) People segregate certain decisions. Ex. An investor may take a lot of risk with one investment account but establish a very conservative position with another account that is dedicated to her child’s education.
c) Psychologists have found that individuals who make decisions that turn out badly have more regret when that decision was more unconventional.
d) A feeling of ‘good’ or ‘bad’ that consumers may attach to potential purchase or investors attach to a stock.
e) Modifies the analytic description of rational risk-averse investors found in standard financial theory. Higher wealth provides higher utility, but at a diminishing rate. This gives rise to risk aversion. Utility depends on changes in wealth from current level.

Answer 7

e) Modifies the analytic description of rational risk-averse investors found in standard financial theory. Higher wealth provides higher utility, but at a diminishing rate. This gives rise to risk aversion. Utility depends on changes in wealth from current level.

Question 8

Which of the following describe the behavioral bias ‘Regret avoidance’?

a) Decisions are affected by how choices are framed.
b) People segregate certain decisions. Ex. An investor may take a lot of risk with one investment account but establish a very conservative position with another account that is dedicated to her child’s education.
c) Psychologists have found that individuals who make decisions that turn out badly have more regret when that decision was more unconventional.
d) A feeling of ‘good’ or ‘bad’ that consumers may attach to potential purchase or investors attach to a stock.
e) Modifies the analytic description of rational risk-averse investors found in standard financial theory. Higher wealth provides higher utility, but at a diminishing rate. This gives rise to risk aversion. Utility depends on changes in wealth from current level.

Answer 8

c) Psychologists have found that individuals who make decisions that turn out badly have more regret when that decision was more unconventional.

Question 9

Which of the following describe the behavioral bias ‘mental accounting’?

a) Decisions are affected by how choices are framed.
b) People segregate certain decisions. Ex. An investor may take a lot of risk with one investment account but establish a very conservative position with another account that is dedicated to her child’s education.
c) Psychologists have found that individuals who make decisions that turn out badly have more regret when that decision was more unconventional.
d) A feeling of ‘good’ or ‘bad’ that consumers may attach to potential purchase or investors attach to a stock.
e) Modifies the analytic description of rational risk-averse investors found in standard financial theory. Higher wealth provides higher utility, but at a diminishing rate. This gives rise to risk aversion. Utility depends on changes in wealth from current level.

Answer 9

b) People segregate certain decisions. Ex. An investor may take a lot of risk with one investment account but establish a very conservative position with another account that is dedicated to her child’s education.

Question 10

Which of the following describe the behavioral bias ‘framing’?

a) Decisions are affected by how choices are framed.
b) People segregate certain decisions. Ex. An investor may take a lot of risk with one investment account but establish a very conservative position with another account that is dedicated to her child’s education.
c) Psychologists have found that individuals who make decisions that turn out badly have more regret when that decision was more unconventional.
d) A feeling of ‘good’ or ‘bad’ that consumers may attach to potential purchase or investors attach to a stock.
e) Modifies the analytic description of rational risk-averse investors found in standard financial theory. Higher wealth provides higher utility, but at a diminishing rate. This gives rise to risk aversion. Utility depends on changes in wealth from current level.

Answer 10

a) Decisions are affected by how choices are framed.

Question 11

Which of the following descriptions are linked to implementation costs (several answers)?

a) Short selling a security entails costs: short sellers may have to return the borrowed security on little notice, rendering the horizon of the short sale uncertain.
b) Worry that an apparent profit opportunity is more apparent than real (mispricing)
c) The cost of borrowing share to initiate a short sale can fluctuate dramatically – sometimes there are no available shares for borrowing, and hence there is not possible to enter a short sale.
d) Limits on discretion to short securities.
e) Exploiting apparent profit opportunities presumably will limit the activity of traders.

Answer 11

a) Short selling a security entails costs: short sellers may have to return the borrowed security on little notice, rendering the horizon of the short sale uncertain.
c) The cost of borrowing share to initiate a short sale can fluctuate dramatically – sometimes there are no available shares for borrowing, and hence there is not possible to enter a short sale.
d) Limits on discretion to short securities.

Question 12

Which of the following links the correct limit to arbitrage with the correct description?

a) Model risk. Worry that an apparent profit opportunity is more apparent than real (mispricing).
b) Model risk. Incurred in exploiting apparent profit opportunities presumably will limit the activity of traders.
c) Fundamental risk. Worry that an apparent profit opportunity is more apparent than real (mispricing).
d) Fundamental risk. Incurred in exploiting apparent profit opportunities presumably will limit the activity of traders.

Answer 12

a) Model risk. Worry that an apparent profit opportunity is more apparent than real (mispricing).
d) Fundamental risk. Incurred in exploiting apparent profit opportunities presumably will limit the activity of traders.

Question 13

What is true about the dispositions effect?

a) A behavioral tendency, which refers to the tendency of investors to hold on to losing investment.
b) Behavioral investors reem reluctant to realize losses
c) This disposition effect can lead to momentum in stock prices even if fundamental values follow a random walk.
d) All of the above

Answer 13

d) All of the above

Question 14

Which of the below describes the breadth of the market?

a) The extent to which a security has outperformed or underperformed either the market as a whole or its particular industry. It’s computed by calculating the ratio of the price of the security to a price index for the industry
b) The average price over a given interval, where the interval is updated as time passes. The average is recomputed every day, by dropping the oldest observation and adding the newest.
c) A measure of the extent to which movement in a market index is reflected widely in the price movements of all the stocks in the market. The most common measure is the spread between the number of stocks that advance and decline in price.

Answer 14

c) A measure of the extent to which movement in a market index is reflected widely in the price movements of all the stocks in the market. The most common measure is the spread between the number of stocks that advance and decline in price.

Question 15

Which of the below describes the moving average of a stock?

a) The extent to which a security has outperformed or underperformed either the market as a whole or its particular industry. It’s computed by calculating the ratio of the price of the security to a price index for the industry
b) The average price over a given interval, where the interval is updated as time passes. The average is recomputed every day, by dropping the oldest observation and adding the newest.
c) A measure of the extent to which movement in a market index is reflected widely in the price movements of all the stocks in the market. The most common measure is the spread between the number of stocks that advance and decline in price.

Answer 15

b) The average price over a given interval, where the interval is updated as time passes. The average is recomputed every day, by dropping the oldest observation and adding the newest.

Question 16

After a period in which prices have been falling, the moving average will be ______ the current price. This is because the moving average continues to average in the older and higher prices until they leave the sample period. In contrast, when prices have been rising, the moving average will be ______ the current price.

a) above, below
b) below, above
c) above, constant
d) constant below

Answer 16

a) above, below

Question 17

What kind of signal is prices breaking through the moving average from below?

a) Bearish
b) Positive
c) This cannot be determined
d) Bullish

Answer 17

d) Bullish

This is because this signifies a shift from a falling trend (with prices moving below the moving average) to a rising trend (with prices above the moving average)

Question 18

Match the sentiment indicators with the descriptions.

a) Trin statistic
b) Confidence index
c) Put/ call ratio

i) The ratio of outstanding put options to outstanding call options.
ii) A trading volume sometimes used to measure the strength of a market rise or fall.
iii) The ratio of the average yield on 10 top-rated corporate bonds divided by the average yield on 10 intermediate-grade corporate bonds.

Answer 18

a) - ii)
b) - iii)
c) - i)

Question 19

True or false.

Technicians consider market advances to be a more favorable omen of continued price increases when they are associated with increased trading volume. Similarly, market reversals are considered more bearish when associated with higher volume.

Answer 19

True

Question 20

Trin is the ratio of average volume in declining issues to average volume in advancing issues. Ratios above 1,0 are considered _____ because the falling stocks would then have higher average volume than the advancing stocks, indicating net selling pressure.

a) Bearish
b) Positive
c) This cannot be determined
d) Bullish

Answer 20

a) Bearish

Question 21

Higher values of the confidence index are _____ signals.

a) Bearish
b) Positive
c) This cannot be determined
d) Bullish

Why?

Answer 21

d) Bullish

The ratio will always be below 1 because higher-rated bonds will offer promised yield to maturity when bond traders are optimistic about the economy, however, they might require smaller default premiums on lower-rated debt. Hence the yield spread will narrow, and the confidence index will approach 1. Therefore, the higher the values of the confidence index are bullish signals.

Question 22

Yield on lower-rated debt will rise after fears of recession have spread through the economy. This will reduce the confidence index. Should the stock market now be expected to fall, or will it already have fallen?

Answer 22

By the time the news of the recession affects bond yields, it also ought to affect stock prices. The market should fall before the confidence index signals that the time is ripe to sell.

Question 23

Jill Davis tells her broker that she does not want to sell her stocks that are below the price she paid for them. She believes that if she just holds on to them a little longer, they will recover, at which time she will sell them. Which behavioral characteristic is the basis for Davis’s decision making?

a) Loss aversion.
b) Conservatism.
c) Representativeness.
d) Regret avoidance

Answer 23

a) Loss aversion.

Question 24

After Polly Shrum sells a stock, she avoids following it in the media. She is afraid that it may subsequently increase in price. Which behavioral characteristic is the basis for Shrum’s decision making?

a) Fear of regret.
b) Representativeness.
c) Mental accounting.

Answer 24

a) Fear of regret. She wants to avoid the feeling of regret from having sold a stock that has increased in value

Question 25

All of the following actions are consistent with feelings of regret except:

a) Selling losers quickly.
b) Hiring a full-service broker.
c) Holding on to losers too long.

Answer 25

b) Hiring a full-service broker. Hiring a full-service broker is not consistent with regret feelings, because you will not have any regret since you have delegated the responsibility to a professional. This could actually prevent regrets, due to reallocation of decisions.

a) Consistent with the feeling of regret, because you don’t want to regret if losers end up decreasing further.
c) Certainly consistent with the following of regret, because if the investors hold on to loser, he doesn’t want to regret selling it and regretting if the price increase.

Question 26

Which of the following describe the disposition effect?

a) Investors are slow to update their beliefs when given new evidence.
b) Investors are reluctant to bear losses caused by their unconventional decisions.
c) Investors exhibit less risk tolerance in their retirement accounts vs. their other stock accounts.
d) Investors are reluctant sell stocks with ‘paper’ losses.
e) Investors disregard sample size when forming views about the future from the past.

Answer 26

d) Investors are reluctant sell stocks with ‘paper’ losses.

Question 27

Which of the following describe the representativeness bias?

a) Investors are slow to update their beliefs when given new evidence.
b) Investors are reluctant to bear losses caused by their unconventional decisions.
c) Investors exhibit less risk tolerance in their retirement accounts vs. their other stock accounts.
d) Investors are reluctant sell stocks with ‘paper’ losses.
e) Investors disregard sample size when forming views about the future from the past.

Answer 27

e) Investors disregard sample size when forming views about the future from the past.

Question 28

Which of the following describe the regret avoidance ?

a) Investors are slow to update their beliefs when given new evidence.
b) Investors are reluctant to bear losses caused by their unconventional decisions.
c) Investors exhibit less risk tolerance in their retirement accounts vs. their other stock accounts.
d) Investors are reluctant sell stocks with ‘paper’ losses.
e) Investors disregard sample size when forming views about the future from the past.

Answer 28

b) Investors are reluctant to bear losses caused by their unconventional decisions.

Regret avoidance are often linked to unconventional decisions.

Question 29

Which of the following describe the conservatism bias?

a) Investors are slow to update their beliefs when given new evidence.
b) Investors are reluctant to bear losses caused by their unconventional decisions.
c) Investors exhibit less risk tolerance in their retirement accounts vs. their other stock accounts.
d) Investors are reluctant sell stocks with ‘paper’ losses.
e) Investors disregard sample size when forming views about the future from the past.

Answer 29

a) Investors are slow to update their beliefs when given new evidence.

Question 30

Which of the following describe the mental accounting?

a) Investors are slow to update their beliefs when given new evidence.
b) Investors are reluctant to bear losses caused by their unconventional decisions.
c) Investors exhibit less risk tolerance in their retirement accounts vs. their other stock accounts.
d) Investors are reluctant sell stocks with ‘paper’ losses.
e) Investors disregard sample size when forming views about the future from the past.

Answer 30

c) Investors exhibit less risk tolerance in their retirement accounts vs. their other stock accounts.

Question 31

True or false.

Fundamental risk is the risk associated with investors becoming less irrational in the short run – that demand and supply will not return to rationality in the short run.

Answer 31

False

Fundamental risk is the risk associated with investors becoming more irrational in the short run – that demand and supply will not return to rationality in the short run.

Question 32

What is data mining?

Answer 32

Data Mining: sorting through large amounts of historical data to uncover systematic patterns that can be used as the basis of a trading strategy. The risk of data mining, and statistical arbitrage in general, is that historical relationships may break down when fundamental economic conditions change or, indeed, that the apparent patterns in the data may be due to pure chance.

Question 33

What does a Trin ratio of 0,7675 signalize?

Answer 33

This signals a bullish market, since the ratio is below 1.

Question 34

What does a breadth of 1067 imply?

Answer 34

Since the breadth (spread) is positive, it indicates a bullish signal. However, in practice, one would not use a one-day measure for the market signal being bullish/ bearish.

Question 35

If the cumulative breadth is negative, is this a bearish or bullish signal?

Answer 35

Bearish

Question 36

What does a declining confidence index imply?

Answer 36

The confidence index this year has declined compared to last year, which indicates an increased spread – signaling a bearish market. The lower confidence index values reflect bearish signal: when bond traders are pessimistic about the economy, they require larger default premiums on lower-rates bonds – the low to high rated bond YTM spread goes up.