Week 2: Efficient Market and Behavioural Finance

Question 1

Can you beat the market?

Answer 1

Hard to systematically beat the market, but possible to exploit inefficiencies

Question 2

Jim Cramer example regarding beating the market.

Answer 2

He was beleived to be highly educated and experienced regarding stocks. He ensured viewers that everything was okay with Bear Staerns, a few days later it failed.
Lesson: intelligent, well educated, experienced experts fail to make good decisions on a regular basis

Question 3

When people invest, they normally have problems regrading what to buy. How do they overcome this?

Answer 3

They usually try to diversify by buying some kind of fund. E.g. Mutual/ active fund. These portfolios are managed by professionals and typically have a small performance fee such as 0.9%.

Question 4

What is a passive fund ?

Answer 4

Passive investing is a long-term strategy for building wealth by buying securities that mirror stock market indexes and holding them long term. It can lower risk, because you’re investing in a mix of asset classes and industries, not an individual stock.

Question 5

How costly is a passive fund?

Answer 5

Typically ultra low cost. E.g. 0.01%.

Question 6

Can fund managers beat the market?

Answer 6

Although fund managers have high levels of education and expertise, they are not guaranteed to beat the market.

Question 7

Are those that beat the market this year, likely to beat it again next year?

Answer 7

No, funds that beat the market usually get lucky. So those that beat the market this year, usually don’t beat it next year

Question 8

Why is it so hard to beat the market?

Answer 8

Fund managers are not stupid.
The power of stock market prices to quickly reflect available information. When new information becomes available it is quickly incorporated into market prices
That doesn’t leave much room for fund managers or individuals to profit from new information

Question 9

The challenger disaster

Answer 9

In 1986, a space shuttle exploded. Within 2 hours, the market conducted who they though caused the disaster and their stock prices fell drastically. This was before a professional investigation confirmed it was that company at fault. This shows how knowledgable the stock market is and how they are usually quicker to respond that a proper investigation.

Question 10

What are the 3 forms of market efficency?

Answer 10

1) Weak form market efficiency
2) Semi-strong market efficiency
3) Strong-market efficiency

Question 11

What is weak form of market efficiency?

Answer 11

Prices reflect the information contained in the records of past prices. Impossible to make consistent superior profits by studying the past returns.

Question 12

What is semi-strong market efficiency

Answer 12

Prices reflect not just past prices but all other public information
Eg. information posted on the internet and reported by the financial press.
Prices will immediately adjust to public information. E.g. Proposal to merge two companies.

Question 13

What is strong-market efficiency?

Answer 13

Price reflects all the information that can be acquired on the company and the economy. Even insider information cannot enable an investor to beat the market. No superior investment manager should consistently beat the market.

Question 14

Why does Technical Analysis fails?

Answer 14

If there is a profitable pattern, everyone would do it
If everyone follows the same strategy competition will eliminate any opportunity associated with the pattern

Question 15

What are the properties of an efficient market?

Answer 15

1) Random and unpredictable
2) Prices should react quickly and correctly to news.
3) Investors cannot earn abnormal, risk adjusted returns (Or atleast it shouldn’t be easy).

Question 16

Name 3 anomalies in the market:

Answer 16

1) The size effect
2) The January effect
3) Momentum effect

Question 17

What is the size effect anomaly?

Answer 17

The smaller companies give us a higher return in comparison to big companies.

Question 18

What is the January effect anomaly?

Answer 18

A market anomaly whereby stock prices regularly tend to rise in the first month of the year.

Question 19

What is the momentum effect anomaly?

Answer 19

The momentum anomaly occurs when the prices of assets that have been rising tend to keep rising, and falling prices tend to continue falling.

Question 20

What is behavioural Finance?

Answer 20

an area of study focused on how psychological influences can affect market outcomes.

Question 21

what is individual bias? (Behavioural finance)

Answer 21

The brain does not process information like a computer, it processes in through shortcuts and filers to shorten analysis time. These filler and shortcuts could lead to predictable errors in investing.

Question 22

What is herding behaviour? (Behavioural Finance)

Answer 22

The tendency for individuals to mimic the actions of a larger group.
Reason: societal pressure, common rational that a large group can’t be wrong.
Costs: Transaction costs; too late to enter the game and you’ll lose money.

Question 23

What is Overconfidence ? (Behavioural Finance)

Answer 23

People overestimate precision of beliefs or forecasts, and overestimate abilities.
Overconfident investing: Overconfident investors trade more but with lower yield

Question 24

What is the prospect theory?

Answer 24

It describes how individuals assess their loss and gain perspectives in an asymmetric manner

Question 25

What does concave mean in regards to prospect theory?

Answer 25

Risk averse over gains

Question 26

What does convex mean in regards to the prospect theory?

Answer 26

Risk seeking over losses

Question 27

What are the 4 key effects derived from the prospect theory?

Answer 27

1) Risk aversion in gains, risk seeking in losses
2) Loss aversion
3) Endowment effect
4) Disposition effect

Question 28

Explain Risk aversion/ seeking (1)

Answer 28

More people want a sure gains, not take a risk
But more people are risk seeking when its regrading making a loss.
Although both outcomes in both scenarios have same expected return.

Question 29

Explain loss aversion (2)

Answer 29

You have an investment opportunity
50% chance of gaining $100 or 50% chance of losing $100.
Although the expected value is zero, most investors would reject this gamble due to loss aversion.
The pain of losing $100 looms larger than the pleasure of gainin

Question 30

Explain the endowment effect (3)

Answer 30

Owner values something higher simply because the own it.
People expects more money while selling, but wants to pay less while buying the same amount of goods.

Question 31

Explain the disposition effect (4):

Answer 31

refers to our tendency to prematurely sell assets that have made financial gains, while holding on to assets that are losing money. We are driven to sell our winning investments in order to ensure a profit, but are averse to selling losing investments in hopes of turning them into gains.

Question 32

Why do firms pay dividends ( Prospect theory pov) ?

Answer 32

Results in a higher perceived utility due to the concavity of value in the domain of gains
(LOOK AT THE DIAGRAM ON THE PPT)