Chapter 9 - Behavior Finance And Technical Analysis

Question 1

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

Answer 1

Conservatism Bias

Question 2

Investors are reluctant to bear losses due to their unconventional decisions.

Answer 2

Regret Avoidance

Question 3

Investors exhibit less risk tolerance in their retirement accounts versus their other stock accounts.

Answer 3

Mental Accounting

Question 4

Investors are reluctant to sell stocks with “paper” losses.

Answer 4

Disposition Effect

Question 5

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

Answer 5

Representation Bias

Question 6

After reading about three successful investors in The Wall Street Journal you decide that active investing will also provide you with superior trading results. What sort of behavioral tendency are you exhibiting?

Answer 6

Representativeness Bias

Sample size isn’t considered when making future decisions.

Question 7

What do we mean by fundamental risk?

Answer 7

Even if a security is mispriced, it’s still risky to attempt to exploit the mispricing.
Correction could happen after the trader’s investing horizon.

Question 8

Why may such risk allow behavioral biases to persist for long periods of time?

Answer 8

No one takes advantage of mispriced securities.

Question 9

What are the strong points of the behavioral critique of the efficient market hypothesis?

Answer 9

Strength relies on observed market inefficiencies and unexplained market behavior.

Question 10

What are some problems with the critique?

Answer 10

Many abnormalities, yet many can be explained.

Rarely meet the test of statistical significance.

Question 11

What are some possible investment implications of the behavioral critique?

Answer 11

Tendency for investors to assume more than actually claimed by the field.
Doesn’t purpose to be a predictor of future returns.

Question 12

Jill Davis tells her broker that shoe 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. What behavioral characteristics does Davis have as the basis for her decision making?

Answer 12

Loss Aversion

Question 13

After Polly Shrum sells a stock, she avoids following it in the media. She is afraid that it may subsequently increase in price. What behavioral characteristic does Shrum have as the basis for her decision making?

Answer 13

Fear of Regret

Question 14

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 14

A

Question 15

Which one of the following would be a bullish signal to technical analyst using moving average rules?
A. A stock price crosses above its 52-week moving average
B. A stock price crosses below its 52-week moving average
C. The stock’s moving average is increasing
D. The stock’s moving average is decreasing

Answer 15

B

Question 16

Yesterday, the Dow Jones industrials gained 54 points. However, 1,704 issues declined in price while 1,367 advanced. Why might a technical analyst be concerned even though the market index rose on this day?

Answer 16

Lack of breadth.
Even though index is up, more stocks declined than advanced.
Indicates “lack of broad-based support” for the rise in the index.

Question 17

Monty Frost’s tax-deferred retirement account is invested entirely in equity securities. Because the international portion of this portfolio has performed poorly in the past, he has reduced his international equity exposure to 2%. Frost’s investment adviser has recommended an increased international equity exposure. Frost responds with the following comment:
Based on past poor performance, I want to sell all my remaining international equity securities once their market prices rise to equal their original costs.
Frost’s advisor is familiar with behavioral finance concepts but prefers a traditional or standard finance approach (modern portfolio theory) to investments.
Indicate the behavioral finance concept that frost most directly exhibits in comment. Explain how each of Frost’s comment can be countered using an argument from standard finance.

Answer 17

Reference dependence example.
In standard finance, alternatives are evaluated in terms of terminal wealth values or final outcome, not in terms of gains or losses to a reference point.

Question 18

Monty Frost’s tax-deferred retirement account is invested entirely in equity securities. Because the international portion of this portfolio has performed poorly in the past, he has reduced his international equity exposure to 2%. Frost’s investment adviser has recommended an increased international equity exposure. Frost responds with the following comment:
Most diversified international portfolios have had disappointing results over the past other markets, even our own. If I do increase my international equity exposure, I would prefer that the entire exposure consist of securities from country XYZ.
Frost’s advisor is familiar with behavioral finance concepts but prefers a traditional or standard finance approach (modern portfolio theory) to investments.
Indicate the behavioral finance concept that frost most directly exhibits in comment. Explain how each of Frost’s comment can be countered using an argument from standard finance.

Answer 18

Susceptibility to Cognitive Error

In standard finance, investors evaluate performance in portfolio terms.

Question 19

Monty Frost’s tax-deferred retirement account is invested entirely in equity securities. Because the international portion of this portfolio has performed poorly in the past, he has reduced his international equity exposure to 2%. Frost’s investment adviser has recommended an increased international equity exposure. Frost responds with the following comment:
International investments are inherently more risky. Therefore, I prefer to purchase any international equity securities in my “speculative” account, my best chance at becoming rich. I do not want them in my retirement account, which has to protect me from poverty in my old age.
Frost’s advisor is familiar with behavioral finance concepts but prefers a traditional or standard finance approach (modern portfolio theory) to investments.
Indicate the behavioral finance concept that frost most directly exhibits in comment. Explain how each of Frost’s comment can be countered using an argument from standard finance.

Answer 19

Mental Accounting
In standard finance, decisions consider risk and return profile of the entire portfolio rather than anticipating gains or losses on any particular account, investment, or class of investments.

Question 20

Louise and Christopher Maclin live in London, United Kingdom, and currently rent an apartment in the metropolitan area. During an initial discussion of the Maclins’ financial plans, Christopher Maclin makes the following statement to the Maclins’ financial adviser, Grant Webb:
“I have used the Internet extensively to research to outlook for the housing market over the next five years, and I believe now is the best time to buy a house.”
Identify the behavioral finance concept most directly exhibited. Explain how each concept is affecting the Maclins’ investment decision making.

Answer 20

Illusion of Knowledge - thinks he’s an expert, but may not be able to analyze the information.
Overconfidence - misinterpret the accuracy of information and skill to analyzing it.

Question 21

Louise and Christopher Maclin live in London, United Kingdom, and currently rent an apartment in the metropolitan area. During an initial discussion of the Maclins’ financial plans, Christopher Maclin makes the following statement to the Maclins’ financial adviser, Grant Webb:
“I do not want to sell any bond in my portfolio for a lower price than I paid for the bond.”
Identify the behavioral finance concept most directly exhibited. Explain how each concept is affecting the Maclins’ investment decision making.

Answer 21

Reference Point - reference point to purchase price.

Question 22

Louise and Christopher Maclin live in London, United Kingdom, and currently rent an apartment in the metropolitan area. During an initial discussion of the Maclins’ financial plans, Christopher Maclin makes the following statement to the Maclins’ financial adviser, Grant Webb:
“I will not sell any of my company stock because I know my company and I believe it has excellent prospects for the future.”
Identify the behavioral finance concept most directly exhibited. Explain how each concept is affecting the Maclins’ investment decision making.

Answer 22

Familiarity - based on familiarity and not sound investment and portfolio principles.
Representativeness - confusing his company with the company’s stock and its future performance.

Question 23

During an interview with her investment adviser, a retired investor made the following statement:
“I have been very pleased with the returns I’ve earned on Petrie stock over the past two years, and I am certain that it will be a superior performer in the future.”
identify which principle of behavioral finance is most consistent with the investor’s statement.

Answer 23

Principle of biased expectations/overconfidence.

Question 24

During an interview with her investment adviser, a retired investor made the following statement:
“I am pleased with the returns from the Petrie stock because I have specific uses for that money. For that reason, I certainly want my retirement fund to continue owning the Petrie stock.”
identify which principle of behavioral finance is most consistent with the investor’s statement.

Answer 24

Principle of mental accounting