CHAPTER 7 – INTRO TO BEHAVIORAL FINANCE

Question 1

What is an efficient market?

Answer 1

An efficient market is one that cannot be beaten and therefore implies holding the market index.

Question 2

What are some Efficiency assumptions

Answer 2

◦ Investors are rational, evaluating information probabilistically.
◦ Prices settle at equilibrium.
◦ Instantaneous price change only when new information arrives.
◦ Prices follow a random walk and are non-random, do not trend

Question 3

What does EMH imply?

Answer 3

 It should rule out the possibility of trading systems.
 No one should be able to consistently beat the market.
 No payoff for information gathering and processing.
 With no new information prices should oscillate in random and unbiased fashion, see figure 7.1.

Question 4

What are some assumptions of EMH (these are all critiqued)?

Answer 4

1. Investors are rational.
2. Investors errors are uncorrelated.
3. Arbitrages forces are possible.

Question 5

What are some empirical challenges to EMH?

Answer 5

1. Price volatility
2. Predictability with stale/past information
3. Predictability studies with excess risk-adjusted returns

Question 6

What are some psychological factors, judgment & cognitive errors all investors make

Answer 6

1. Conservatism bias: too little weight given to new information
2. Confirmation Bias: an investor’s beliefs become more extreme over time.
3. Anchoring: an individual’s inability to sway from initial estimates/forecasts (anchor) even if they are irrelevant, sizing a prediction based on numbers previously given.
4. Optimism / Overconfidence: Investors are generally overconfident about the quality and precision of their knowledge.
5. Crime of small numbers: using too small of a sample size to draw a conclusion resulting in two judgment errors.
6. Imitative behavior / herding: looking at behavior of others for cues.
7. Mental accounting: contributes to positive feedback.
8. Ponzi schemes / Bubbles
9. Self attribution: attributing successful results to our own ability (we take credit for positive outcomes), unsuccessful results attributed to “bad luck”.
10. Prospect theory: How investors value gains and losses differently.

Question 7

1. A trader wants to purchase 1000 shares of GoldPro Mines. The stock is relatively illiquid so he wants to ensure his order is executed today and also wants the order to be completed in full. What type of order should he place?

Answer 7

Answer: (Market order, good for the day (day order), all or none)

Question 8

2. A Portfolio Manager is looking to manage risk in her portfolio and wants to protect her position in ABC Co over the next month. The stock is currently trading at $25. She wants to sell if her stock declines to $20 but not below $19. What type of order should she place?

Answer 8

Answer: (Stop loss trigger 20, stop limit 19)