Investments Ch 6 Flashcards
HISTORY OF FINANCIAL DECISION MAKING
HISTORY OF FINANCIAL DECISION MAKING
- Measuring risk and assessing possible outcomes
- Cognitive errors and emotional biases
- Examples of investment bubbles:
- 1840s UK railroad industry
- Early 1980s Japanese stock market
- 1929 and 1987 U.S. stock market
- Late 1990s Dot.com stocks
- 2008 housing market
MODERN PORTFOLIO THEORY
Modern Portfolio Theory holds that all investors are risk-averse and
rational and that they follow these rules:
MODERN PORTFOLIO THEORY
Modern Portfolio Theory holds that all investors are risk-averse and
rational and that they follow these rules:
- Make decisions that maximize expected utility
- Forecast without biases
- Make decisions using rational expectations
- Maintain indifference curves along their efficient frontiers
MODERN PORTFOLIO THEORY ASSUMPTIONS
- Financial security returns are random variables and can be
fully described by their means and standard deviations. - Investors are rational and risk averse.
- Investors make decisions that maximize their expected
wealth. - There are no trading costs (taxes, fees, bid-ask spreads, etc.).
- Investors are price takers. Their trades have no impact on
prices. - Investors form homogeneous expectations about risk and
expected returns because they have identical information
sets. - Investors can borrow and lend at the risk-free rate of interest
THE EFFICIENT MARKET HYPOTHESIS
EMH: Developed by Eugene Fama
- Relevant information is reflected in asset prices.
- Changes in relevant information will be immediately and
completely reflected in changing asset prices.
There are three levels of informational efficiency:
1. Weak form – Historical Prices and volume data
2. Semi-strong form – Publicly available information
3. Strong form – All relevant information including private
EFFICIENT MARKET ASSUMPTIONS
EFFICIENT MARKET ASSUMPTIONS
- Financial markets are informationally efficient (prices reflect relevant information).
- Investors form rational expectations regarding future price movements. * Security prices follow a random walk, suggesting that price changes are random and therefore unpredictable.
- Changes in relevant information (which are random) will instantaneously be reflected in an asset’s price.
- Price changes are unbiased and virtually impossible to predict. * There are large numbers of financial market participants who maximize profits as they process new and relevant information.
- Three levels of market efficiency are weak form, semi-strong form, and strong form.
WEAK FORM MARKET
- Asset prices reflect historical pricing and volume information.
- Investors cannot use this information set (past prices and volume) to generate a return that exceeds its risk adjusted expected value
SEMI-STRONG FORM MARKET
- Asset prices reflect all publicly available information.
- Investors cannot use publicly available information to generate an
excess return. - Examples of information reflected in asset prices:
–Firm related
–Market related
STRONG FORM MARKET
- Asset prices reflect all relevant information, including private
information. - The implication is that investors cannot use any information,
including private information, to generate an excess return.
MARKET ANOMALIES
MARKET ANOMALIES
- January Effect
- Dogs of the Dow
- Low Price to Book Value
- Neglected Firm Effect
BEHAVIORAL FINANCE
BEHAVIORAL FINANCE (1 OF 2)
- Focuses on the decision-making process
- Offers a link to political science, sociology, and psychology
- Investors are influenced by emotions when making decisions under
uncertainty. - Investors are influenced by group dynamics.
COMPARISON OF TRADITIONAL AND BEHAVIORAL FINANCE
BEHAVIORAL FINANCE
BEHAVIORAL FINANCE (2 OF 2)
- In a behavioral finance framework, financial decision makers are
not the perfect machines assumed in modern portfolio theory. - Much evidence suggests that investors are subject to a variety
of behavioral biases. - A behavioral market is one that is imperfect, with trading by
individuals with emotional baggage who make cognitive mistakes
during the investment process.
BEHAVIORAL FINANCE: ASSUMPTIONS
BEHAVIORAL FINANCE: ASSUMPTIONS
- Decision makers are not perfectly rational agents and they exhibit bounded rationality.
- Investors are easily influenced by their peers.
- Investors view gains and losses differently from each other and their decisions are characterized by prospect theory.
- Investors make information processing errors that result in over reaction and under reaction to information changes.
- Investors make processing errors.
- Investors are emotional.
FRAMING VS. NARROW FRAMING
FRAMING VS. NARROW FRAMING
Framing
* Investment decisions can be influenced by the manner in which the
decision is framed.
Narrow Framing
* Attaching great importance to the individual components of a portfolio rather than viewing the portfolio in its entirety
PROSPECT THEORY
PROSPECT THEORY
- Investors incorrectly estimate probabilities and the associated
outcomes - Overweight small chance outcomes just to avoid a loss
- Make decisions that minimize feeling of regret, which makes them
loss averse - Forecast in the presence of a variety of biases
- Make decisions using naïve expectations
BEHAVORIAL FINANCE AND COGNITIVE ERRORS
BEHAVORIAL FINANCE AND COGNITIVE ERRORS
Cognitive Errors
* When investors inaccurately process new information about asset
prices
* Common cognitive errors include representativeness, anchoring,
cognitive dissonance, gambler’s fallacy, and mental accounting
REPRESENTATIVENESS
REPRESENTATIVENESS
- An assessment of new information or decisions based on superficial
traits rather than fundamental analysis
ANCHORING AND COGNITIVE DISSONANCE
ANCHORING AND COGNITIVE DISSONANCE
Anchoring
* The use of immaterial information in making investment decisions
Cognitive Dissonance
* Ignoring or discounting new information that is not consistent with
the investor’s fundamental view
COGNITIVE ERRORS
COGNITIVE ERRORS
Gambler’s Fallacy: The
mistaken notion that the
onset of an outcome either
increases or decreases the
probability of that outcome
occurring again
Mental Accounting:
Investors make decisions
based on individual mental
categories, which can be
unique to each investor.
ADDITIONAL COGNITIVE ERRORS
Illusion of Control:
Investors expect a different outcome
than others because they believe they can exert some form
of control over the outcome when in fact they cannot
Hindsight Bias: Investors conveniently forget bad outcomes
and remember good ones. This leads to the repeat of
historical trading errors and an inaccurate judgment on the
portfolio winners
Confirmation Bias: Investors search for information that
supports their viewpoint while avoiding disagreeing positions.
BEHAVIORAL FINANCE & EMOTIONAL BIASES
BEHAVIORAL FINANCE & EMOTIONAL BIASES
Loss Aversion
* Behavioral investors arrange their portfolios to avoid losses rather
than structuring them to generate gains because the pain of loss is
so great.
Regret Aversion
* Similar to loss aversion, regret aversion is the fear of making poor
decisions. Picking losers is a signal of bad judgment and investors
hope to avoid being labeled as such.
OTHER BIASES
* Overconfidence
* Self-control
* Clustering Illusion
* Optimism bias
SUMMARY OF BEHAVIORAL CONSEQUENCES
Imperfect Diversification Missed Opportunities
SUMMARY OF BEHAVIORAL CONSEQUENCES
Imperfect Diversification Missed Opportunities
_______________________________________________________________
Representativeness Anchoring
Gambler’s Fallacy Cognitive Dissonance
Illusion of Control Mental Accounting
Loss Aversion Hindsight Bias
Overconfidence Lack of Self-Control
Optimism Bias Clustering Illusion
HERD MENTALITY
HERD MENTALITY
* Managers often receive pressure from their clients when an
investment trend is taking place.
* Clients encourage money managers to pursue such strategies
MONEY MANAGERS & BEHAVIORAL ISSUES
MONEY MANAGERS & BEHAVIORAL ISSUES
CONCLUDING REMARKS
CONCLUDING REMARKS
There is much evidence to contradict the severe assumptions of
modern portfolio theory and the efficient markets hypothesis.
- Markets today are not perfectly efficient.
- There are inefficiencies that may allow skilled investors to gain
advantage over less informed investors. - Prices tend to drift away from their efficient market equilibrium
levels. - While mispricing may provide investment opportunity, it has been
shown that it is difficult to beat the market consistently.
STEPS TO BALANCE BETWEEN THEORIES
Step One: Investors should find their optimal portfolios outlined by
Markowitz.
Step Two: Determine if any cognitive or emotional biases exist that
warrant a change to asset selection or allocation.
Step Three: Carefully monitor both portfolio performance and any biased behavior to ensure investors can reach their financial goals. Successful investment strategies must include both traditional and behavioral elements
Which of the following forms of the efficient market hypothesis supports “ technical analysis “ ?
Weak Form Semi-Strong Form Strong Form None of the choices
D None of these
Which of the following forms of the efficient market hypothesis supports fundamental analysis?
A. Weak Form B. Semi-Strong Form C. Strong Form D. None of the choices
Solution: The correct answer is A.
Only the weak form accepts Fundamental Analysis as a viable investment approach.
The efficient market hypothesis asserts that stocks follow:
Predictable pattern Random walk Both choices Neither choice
Random walk
A market in which an investor can consistently outperform the market long term on a risk-adjusted basis by investing solely in companies run by CEO’s with more than 10 years experience is most likely:
Inefficient
Weak form efficient.
Semi-strong form efficient.
Strong form efficient.
Inefficient.
Rationale
Efficient market fully reflect all relevant information and hence that information cannot be used to outperform the market over the long term. The experience of a CEO is publicly available information, and hence would be fully reflected in prices even in a weak form efficient market.
An investor adds a second corporate bond to her portfolio after the first bond substantially outperformed during the previous year. The first bond has been upgraded after its recent performance from CC to CCC. The second bond is currently rated CC and the investors seeks a repeat performance based on no additional information. The investor is most likely suffering from:
Gambler’s fallacy.
Rationale
The gambler’s fallacy is the thought that an investor has influence over an outcome because of a previous experience with a similar event. In this case, the investor is hoping to repeat the outperformance just because one speculative grade bond performed well.
A financial analyst runs a comprehensive study using 600 months of return data for an equity market.
She finds that portfolios constructed by investing in companies that increase their dividend payment by more than 10%, in companies that fire their chief executive for incompetence, in companies that sponsor professional golf tournaments, and in companies that improve their current ratios generate the same return as a benchmark with similar risk.
The analyst is most likely to conclude that the market is:
Inefficient.
Weak form efficient.
Semi-strong efficient.
Semi-strong efficient.
Rationale
The semi-strong form of market efficiency suggests that prices reflect all publicly available and relevant information. Clearly, dividends, ratios, board of director decisions, and business relationships are public knowledge and should be reflected in prices, making this scenario a semi-strong form of market efficiency.
Charlie has been trading in stocks on a very short term basis for several months. Although he had good results at first, the volume of his activity created significant trading costs and he has recently been incurring losses regularly. He continues to trade frequently regardless of the outcome because of the adrenaline rush associated with day trading. Which emotional bias is he committing?
Self-control bias.
Which of the following is the most accurate description of the difference between what behavioral and rational
investors value?
Option: Behavioral Rational
a Gains and losses Final wealth (end of period )
b Gains Losses
c Losses Final wealth
d Final wealth Final wealth
Option a.
Rationale
One of the significant differences between investors that are rational and those who exhibit behavioral tendencies is their goals.
Rational investors value end of period wealth while those influenced by emotions and heuristics value both short and long-term gains and losses.
This difference can lead to completely different portfolio construction
The behavioral finance aspect that most likely offers a unique and reasonable explanation for the persistence of the equity premium puzzle is
Myopic loss aversion.
Rationale
Investors tend to avoid short-term losses at the expense of other portfolio components. The implication is that investors require very high long-term returns to compensate them for the losses occurring in the short term. Therefore, myopic loss aversion offers a reasonable explanation for the difference between equity returns and government bond yields that cannot be explained by differences in risk.
Which of the following investor traits is least likely to be classed as a behavioral bias?
A preference for taking a short cut in order to make a quick asset allocation transaction.
The failure to completely process new information relating to an existing investment.
A tendency to invest based on emotional biases.
The tendency to display risk aversion when deciding between securities.
The tendency to display risk aversion when deciding between securities.
Rationale
Behavioral investors are loss averse, not risk averse. They also take shortcuts, only process information, partially, and have emotional biases and make cognitive errors.
THE most likely violation of the modern portfolio theory assumptions is ??
Investors making rational decisions.
Institutional investors having no impact on prices even when making large trades.
Individual investors facing bid and ask prices when they trade
All investors being able to borrow at the risk-free rate of interest.
Individual investors facing bid and ask prices when they trade.
Rationale
MPT assumptions include the existence of markets that have no transactions costs. Bid-ask spreads are one form of transactions cost. The remaining choices are critical MPT assumptions
Prospect theory most likely suggests investors:
Avoid regret when making important financial decisions.
Rationale
Prospect theory suggests that behavioral investors will make decisions to avoid the feelings of regret, such as signaling to the rest of the capital markets that they have selected a losing stock. Behavioral investors are rationally bounded, take short cuts (heuristics) and have many emotional biases.
Modern portfolio theory was originally advanced by:
Harry Markowitz and the identification of standard deviation as a measure of risk.
Rationale
Harry Markowitz wrote his seminal paper on the efficient frontier in 1952. This research is considered to be the
origination of modern portfolio theory, which formed the basis of the CAPM, the EMH, and APT that followed by
Sharpe, Fama, and Ross. Markowitz was the first to understand the importance of standard deviation in risk management. All of these researchers are considered to be the fathers of modern finance.
Which is least accurate regarding stock market anomalies?
The lowest dividend yielding Dow firms outperform the Dow Index.
Rationale
The Dogs of the Dow are those firms that pay the highest dividends among the firms in the index. They tend to have the lowest prices and they outperform the entire index
Yolanda recently reviewed her portfolio as part of her year-end performance assessment. She sold several stocks that had positive results for the year but held on to two stocks that were below her purchase price. She did not re-evaluate the potential performance for these stocks. Which form of bias is she exhibiting?
Loss aversion.
Rationale
Hindsight bias occurs when investors recall positive outcomes but fail to remember the negative one.
Confirmation bias entails searching for information that supports your existing position.
Overconfidence bias occurs when investors overestimate their ability to identify mispriced securities.
Which of the following investor traits is least likely to be classed as a behavioral bias?
The tendency to display risk aversion when deciding between securities.
Rationale
Behavioral investors are loss averse, not risk averse. They also take shortcuts, only process information, partially, and have emotional biases and make cognitive errors.
The Big Mountain Mutual Fund is a powerful institutional investor that regular moves prices upward or downward depending on its net position in specific equity securities. Recently, and after substantial due diligence, Big Mountain announced it was short 10 million shares of Galactic Energy, whose price subsequently dropped by 20% overnight. Which statement regarding Big Mountain is most accurate
Big Mountain’s influence on prices is a violation of modern portfolio assumptions.
Rationale
Modern portfolio theory relies on an assumption that all investors are price takers, implying that no individual or institutional investor can impact prices with their portfolio decisions.
Big Mountain is able to move prices with its investment decisions, making it a violation of the assumptions.
TEST
TEST
- Technical Analysis - What does it include, what does it not include?
-is another method that may help determine the price at which an investor should buy, sell, or hold an individual equity security.
-Guided by the principles of supply and demand.
-Technical analysts attempt to determine the demand for an asset (stock) by observing the movements in past prices and volume.
-Based on the belief that past movements in the asset will help to predict future patterns and prices. - BEHAVIORAL FINANCE: ASSUMPTIONS
- Decision makers are not perfectly rational agents and they exhibit bounded rationality.
- Investors are easily influenced by their peers.
- Investors view gains and losses differently from each other and their decisions are characterized by prospect theory.
- Investors make information processing errors that result in over reaction and under reaction to information changes.
- Investors make processing errors.
- Investors are emotional
- Loss Aversion
- Narrow Framing
- Biased Self-Attribution
- Representativeness
TEST
Technical Analysis__________________________________________
is the study of the various forces at work in the marketplace and their effect on stock prices.
- Focus on trends in a stock price and the overall stock market.
- Stock prices are a function of supply and demand.
- Helps to predict future movements.
- At the heart of most forms of technical analysis is the desire to
time the market efficiently. - Technician is someone who conducts technical analysis.
TEST
Random Walk Theory -
This theory states that:
* the behavior of stock prices closely resembles a random walk.
* prices of stocks are “unpredictable” but not “arbitrary”.
* at any given moment prices that exist on securities are the best
incorporation of all available information and a true reflection of
the value of that security.
* prices are in equilibrium.
TEST
IN the Theory of Efficient Markets, information sets are reflected i prices. there are Three Forms – Weak, Semi-Strong and Strong
- Weak: Historical information will not help investors achieve
above average market returns. Essentially rejects technical
analysis - Semi-Strong: Historical and public information will not help
investors achieve above average market returns. Rejects
technical and fundamental analysis - Strong: Historical, public and private information will not help
investors achieve above average market returns. Rejects technical
& fundamental analysis, and also inside information. So, diversify
stocks randomly or merely go with an Index
Exam Question
Which of the following forms of the efficient market hypothesis
supports technical analysis?
A. Strong
B. Semi-Strong
C. Weak
D. All of the above
E. None of the above
TEST
Exam Question
Which of the following forms of the efficient market hypothesis
supports technical analysis?
A. Strong
B. Semi-Strong
C. Weak
D. All of the above
E. None of the above «< correct i think ???
TEST
- Behavioral Finance
- Overconfidence
- Biased Self-Attribution -A self-serving bias is any cognitive or perceptual process that is distorted by the need to maintain and enhance self-esteem, or the tendency to perceive oneself in an overly favorable manner.
- Loss Aversion
- Narrow Framing
- Belief Perseverance - is maintaining a belief despite new information that firmly contradicts it. Such beliefs may even be strengthened when others attempt to present evidence debunking them, a phenomenon known as the backfire effect
- Recency Effect - is a cognitive bias in which those items, ideas, or arguments that came last are remembered more clearly than those that came first
3 levels of Informational Efficiency within the Market:
3 levels of Informational Efficiency within the Market: TEST
Technical Fundamental Private Info
Analysis Analysis "Insider "
filings, K1,
Public Info \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ WEAK NO YES YES
_______________________________________________________________
SEMI NO NO YES
STRONG
______________________________________________________________
STRONG NO NO NO
the market is so efficient, that you cannot get a return above the market with any add’l info. , can use Index Funds “
Modern portfolio theory was originally advanced by:
Harry Markowitz and the identification of standard deviation as a measure of risk.
Rationale
Harry Markowitz wrote his seminal paper on the efficient frontier in 1952. This research is considered to be the
origination of modern portfolio theory, which formed the basis of the CAPM, the EMH, and APT that followed by
Sharpe, Fama, and Ross. Markowitz was the first to understand the importance of standard deviation in risk management. All of these researchers are considered to be the fathers of modern finance.
Reese sits on four boards of directors of publicly held companies, each operating in a different industry. She has an ethical clause in each of her board contracts but ignores them by trading on information she learns during board meetings. Reese generates an average return on these trades that is well above any relevant benchmark. If Reese’s strategy was repeatable by all investors over the long term, this would violate which form of the efficient market hypothesis?
Strong-form efficient.
Rationale
Only in a strong form market do prices reflect all relevant information including insider information. Since Reese uses private information to beat the market, it cannot be strong-form efficient.
The random walk hypothesis
implies that security analysis is unable to predict future market behavior. suggests that random patterns appear but only over long periods of time. has been disproved based on recent computer simulations. supports the notion that random price movements are indicative of inefficient markets.
Solution: The correct answer is A.
Solution: The correct answer is A.
implies that security analysis is unable to predict future market behavior.
