Ch14 - Behavioral Finance Application

Question 1

What is the difference between volatility puzzle and stockholding puzzle?

Answer 1

• volatility puzzle - when stocks are far MORE volatile than they should be based on changes in future earnings and interest rates.
• stockholding puzzle - when individuals simply do not own stock because they are _unfamiliar with (or fearful of) the marke_t.

Question 2

Any factor that impacts a rational trader’s ability to force down the price of an overpriced (mispriced) stock is known as _________.

Answer 2

a limit to arbitrage.

Question 3

Investors can display a bias when investing in individual stocks. Explain what each type of bias.

a) overconfidence bias
b) confirmation bias
c) hindsight bias
d) availability bias
e) home bias
f) recency bias

Answer 3

a) overconfidence bias - investors believe that they are better at selecting stocks than the average investor
b) confirmation bias - when we match what we experience with what we expected to experience
c) hindsight bias - the belief that one was able in the past to predict the future
d) availability bias - individuals tend to invest in companies they are familiar with
e) home bias - overweigh stocks within your own geographical region
f) recency bias - investors placing too much value on recent (say 3 month or 1 year) performance of mutual funds

Question 4

What type of assets will reflect a higher or lower expected return?

Answer 4

bonds = lower expected return

stocks = higher expected return

Question 5

This is when investors believe that a high recent performance will continue into the future.

Answer 5

“hot hand” fallacy

Question 6

Investment risk that can be eliminated through diversification.

a) systematic risk (aka - market risk)
b) unsystematic risk

Answer 6

b) unsystematic risk

Question 7

Modern Portfolio Theory is predicated on portfolio diversification and suggests that ALL investors should have a primary goal to…

Answer 7

maximize return for a given level of risk by holding the SAME risky portfolio.

Question 8

Beta measures the covariance of an investment portfolio with market risk.

Beta of 1 = _________

Beta > 1 = _________

Beta < 1 = _________

Answer 8

Beta of 1 = same risk as market portfolio

Beta > 1 = more systematic risk, lower return

Beta < 1 = less systematic risk, high return

Question 9

Expected return on an investment depends on systematic risk (beta). According to CAPM, investors should be compensated for the degree of…

Answer 9

beta they were willing to accept.

Question 10

Expected return on an asset according to CAPM = _________ + _________

Answer 10

risk free rate + risk premium

Question 11

What is the efficient market hypothesis?

Answer 11

A theory that states that the prices of ALL financial assets reflect all available information (public and private) and are priced fairly accordingly to the level of risk.

Question 12

Identify the THREE different forms of the efficient market hypothesis.

a) weak-form - _________
b) semi-strong form - _________
c) strong-form - _________

Answer 12

a) weak-form - investors can earn an excess return through historical research and public information.
b) semi-strong form - investors can earn an excess return through the use of non-public information.
c) strong-form - investors CANNOT earn an excess return.

Question 13

Nobel Prize-winning economist Robert Merton (1972) derived the mutual fund theorem in which he proved that the optimal investor portfolio should consist of what TWO financial assets?

Answer 13

risk-free investment

and

market portfolio

Question 14

The ratio of each asset in the portfolio is determined by the investor’s __________.

Answer 14

risk tolerance

Question 15

What is the “illusion of control”?

Answer 15

When an investor feels that since they have some control the over the portfolio they will do better than the market. This usually results in under-diversification of an asset a portfolio

Question 16

What is the private equity premium puzzle?

Answer 16

When investors believe that they are more likely to outperform the market because they are in control of their investments.

Question 17

The emotional response to markets is known as ________.

Answer 17

sentiment

Question 18

Stocks can be overpriced when there is dispersion of ______, also referred to as a divergence of opinion, regarding the true value of the company.

Answer 18

sentiment

Question 19

This measures changes in how investors feel about the economy, and is correlated with the market.

Answer 19

Consumer Sentiment Index

Question 20

Mutual funds flows tend to follow sentiment resulting in…

Answer 20

large inflows after stocks have RISEN in value and large outflows after stocks FALL in value.

Question 21

__________ means that individuals tend to invest MORE in recent high performing funds and WITHDRAW investments from mutual funds that are underperforming or losing value.

Answer 21

Return chasing

Question 22

Why do investors tend to underperform in mutual funds?

Answer 22

Because of return chasing, investors tend to pour money into hot mutual funds that have high recent returns (eg - recency bias).

Question 23

Why are stocks so volatile in the short run, but NOT AS volatile in the long run?

Answer 23

Because of investor overreaction to new information. When investors see new positive information, such as higher than expected corporate earnings, they tend to get too excited and bid the price beyond its fundamental value. Conversely, when investors get negative information, the price falls too much and the stock eventually recovers.

Question 24

What is the “momentum effect”?

Answer 24

The momentum effects occur when yesterday’s winner continues to win in the short run and losers continue to lose. Positive sentiment can drive a stock price upward, attract more investors, and the price keeps to rising beyond its fundamental value. After reaching this inflated price, the stock eventually underperforms as the price falls back to what it should be. Which is called mean reversion.

Question 25

What is the low volatility anomaly?

Answer 25

Stocks that have greater price volatility have LOWER returns, and stocks that are less volatile have HIGHER returns.

Question 26

Fama and French identified TWO factors, a firm’s price/book value and a firm’s size, as important independent predictors of stock returns. They find that ________ outperform ________ over time.

Answer 26

value stocks and small stocks outperform growth stocks and larger stocks

Question 27

When an investor chooses an actively-managed mutual fund, they expect that a skilled fund manager will provide return above what could be received from a less expensive, passively managed market portfolio. What does Fama and French have to say about this assumption regarding actively-managed mutual funds?

Answer 27

There is NO evidence that skilled fund managers are able to persistently beat the market.