BKM 12

Question 1

4 Information Processing Errors

Answer 1

1) Forecasting errors - giving too much weight to recent experience.
2) Overconfidence - may lean too much high or low end of estimate.
3) Conservatism - investors are too slow in updating their beliefs.
4) Sample size neglect and representativeness - inferring a pattern from a small sample size.

Question 2

5 Behavioral Biases

Answer 2

1) Framing - decisions are affected by how choices are framed.
2) Mental Accounting - segregating decisions may lead to suboptimal ones.
3) Regret Avoidance - an investor may worry about looking foolish should his decision lead to loss.
4) Affect - “good” or “bad” feeling attached to a stock may lead to suboptimal decisions.
5) Prospect Theory - utility depends on changes in wealth from current levels.

Question 3

Market Anomalies

Answer 3

1) Post earnings-announcement price drift - positive news was not reflected immediately and the market took some time to correct itself.
2) Small-firm effect - average annual returns are consistently higher on small-firm portfolios even after accounting for their increased riskiness.
3) Neglected-firm effect - less information is available for neglected firms, which makes them riskier investments that command higher returns.
4) Book-to-Market Ratios - Higher book-to-market stocks produce higher annual average returns.

Question 4

Semi-Strong EMH

Answer 4

All publicly available information would already be reflected in the stock price.

Question 5

Strong EMH

Answer 5

The stock price reflected all information including that available to insiders.

Question 6

EMH and Technical Analysis

Answer 6

EMH implies that technical analysis shouldn’t work because historical trading prices and volume data are publicly available. Any useful information from that data should already be reflected in stock prices.