Chapter 12Behavioral Finance and Technical Analysis

 

Multiple Choice Questions 

1. Conventional theories presume that investors ____________ and behavioral finance presumes that they ____________. A. are irrational; are irrationalB. are rational; may not be rationalC. are rational; are rationalD. may not be rational; may not be rationalE. may not be rational; are rational

Conventional theories presume that investors are rational and behavioral finance presumes that they may not be rational.

 2. The premise of behavioral finance is that A. conventional financial theory ignores how real people make decisions and that people make a difference.B. conventional financial theory considers how emotional people make decisions but the market is driven by rational utility maximizing investors.C. conventional financial theory should ignore how the average person makes decisions because the market is driven by investors that are much more sophisticated than the average person.D. conventional financial theory considers how emotional people make decisions but the market is driven by rational utility maximizing investors, and conventional financial theory should ignore how the average person makes decisions because the market is driven by investors that are much more sophisticated than the average personE. None of these is correct.

The premise of behavioral finance is that conventional financial theory ignores how real people make decisions and that people make a difference.

 

3. Some economists believe that the anomalies literature is consistent with investors' ____________ and ____________. A. ability to always process information correctly and therefore they infer correct probability distributions about future rates of return; given a probability distribution of returns, they always make consistent and optimal decisionsB. inability to always process information correctly and therefore they infer incorrect probability distributions about future rates of return; given a probability distribution of returns, they always make consistent and optimal decisionsC. ability to always process information correctly and therefore they infer correct probability distributions about future rates of return; given a probability distribution of returns, they often make inconsistent or suboptimal decisionsD. inability to always process information correctly and therefore they infer incorrect probability distributions about future rates of return; given a probability distribution of returns, they often make inconsistent or suboptimal decisionsE. None of these is correct.

Some economists believe that the anomalies literature is consistent with investors inability to always process information correctly and therefore they infer incorrect probability distributions about future rates of return and given a probability distribution of returns, they often make inconsistent or suboptimal decisions.

 4. Information processing errors consist of I) forecasting errorsII) overconfidenceIII) conservatismIV) framing A. I and IIB. I and IIIC. III and IVD. IV onlyE. I, II and III

Information processing errors consist of forecasting errors, overconfidence, and conservatism.

 

5. Forecasting errors are potentially important because A. research suggests that people underweight recent information.B. research suggests that people overweight recent information.C. research suggests that people correctly weight recent information.D. research suggests that people either underweight recent information or overweight recent information depending on whether the information was good or bad.E. None of these is correct.

Forecasting errors are potentially important because research suggests that people overweight recent information.

 

6. DeBondt and Thaler believe that high P/E result from investors' A. earnings expectations that are too extreme.B. earnings expectations that are not extreme enough.C. stock price expectations that are too extreme.D. stock price expectations that are not extreme enough.E. None of these is correct.

DeBondt and Thaler believe that high P/E result from investors earnings expectations that are too extreme.

7. If a person gives too much weight to recent information compared to prior beliefs, they would make ________ errors. A. framingB. selection biasC. overconfidenceD. conservatismE. forecasting

If a person gives too much weight to recent information compared to prior beliefs, they would make forecasting errors.

 8. Single men trade far more often than women. This is due to greater ________ among men. A. framingB. regret avoidanceC. overconfidenceD. conservatismE. None of these is correct.

Single men trade far more often than women. This is due to greater overconfidence among men.

 9. ____________ may be responsible for the prevalence of active versus passive investments management. A. Forecasting errorsB. OverconfidenceC. Mental accountingD. ConservatismE. Regret avoidance

Overconfidence may be responsible for the prevalence of active versus passive investments management.

 

10. Barber and Odean (2000) ranked portfolios by turnover and report that the difference in return between the highest and lowest turnover portfolios is 7% per year. They attribute this to A. overconfidenceB. framingC. regret avoidanceD. sample neglectE. overconfidence, framing, regret avoidance, and sample neglect

They attribute this to overconfidence.

 11. ________ bias means that investors are too slow in updating their beliefs in response to evidence. A. FramingB. Regret avoidanceC. OverconfidenceD. ConservatismE. None of these is correct.

Conservatism bias means that investors are too slow in updating their beliefs in response to evidence.

 12. Psychologists have found that people who make decisions that turn out badly blame themselves more when that decision was unconventional. The name for this phenomenon is A. regret avoidanceB. framingC. mental accountingD. overconfidenceE. obnoxicity

An investments example given in the text is buying the stock of a start-up firm that shows subsequent poor performance, versus buying blue chip stocks that perform poorly. Investors tend to have more regret if they chose the less conventional start-up stock. DeBondt and Thaler say that such regret theory is consistent with the size effect and the book-to-market effect.

 13. An example of ________ is that a person may reject an investment when it is posed in terms of risk surrounding potential gains but may accept the same investment if it is posed in terms of risk surrounding potential losses. A. framingB. regret avoidanceC. overconfidenceD. conservatismE. None of these is correct.

An example of framing is that a person may reject an investment when it is posed in terms of risk surrounding potential gains but may accept the same investment if it is posed in terms of risk surrounding potential losses.

 

14. Statman (1977) argues that ________ is consistent with some investors' irrational preference for stocks with high cash dividends and with a tendency to hold losing positions too long. A. mental accountingB. regret avoidanceC. overconfidenceD. conservatismE. None of these is correct.

Statman (1977) argues that mental accounting is consistent with some investors' irrational preference for stocks with high cash dividends and with a tendency to hold losing positions too long.

 15. An example of ________ is that it is not as painful to have purchased a blue-chip stock that decreases in value, as it is to lose money on an unknown start-up firm. A. mental accountingB. regret avoidanceC. overconfidenceD. conservatismE. None of these is correct.

An example of regret avoidance is that it is not as painful to have purchased a blue-chip stock that decreases in value, as it is to lose money on an unknown start-up firm.

 16. Arbitrageurs may be unable to exploit behavioral biases due to ____________. I) fundamental riskII) implementation costsIII) model riskIV) conservatismV) regret avoidance A. I and II onlyB. I, II, and IIIC. I, II, III, and VD. II, III, and IVE. IV and V

Arbitrageurs may be unable to exploit behavioral biases due to fundamental risk, implementation costs, and model risk.

 

17. ____________ are good examples of the limits to arbitrage because they show that the law of one price is violated. I) Siamese Twin CompaniesII) Unit trustsIII) Closed end fundsIV) Open end fundsV) Equity carve outs A. I and IIB. I, II, and IIIC. I, III, and VD. IV and VE. V

Siamese Twin Companies, closed end funds, and equity carve outs are good examples of the limits to arbitrage because they show that the law of one price is violated.

 18. __________ was the grandfather of technical analysis. A. Harry MarkowitzB. William SharpeC. Charles DowD. Benjamin GrahamE. None of these is correct.

Charles Dow, the originator of the Dow Theory, was the grandfather of technical analysis. Benjamin Graham might be considered the grandfather of fundamental analysis. Harry Markowitz and William Sharpe might be considered the grandfathers of modern portfolio theory.

 

19. The goal of the Dow theory is to A. identify head and shoulder patterns.B. identify breakaway points.C. identify resistance levels.D. identify support levels.E. identify long-term trends.

The Dow theory uses the Dow Jones Industrial Average as an indicator of long-term trends in market prices.

 

20. A long-term movement of prices, lasting from several months to years is called _________. A. a minor trendB. a primary trendC. an intermediate trendD. trend analysisE. both a primary trend and trend analysis

Minor trends are merely day-to-day price movements; intermediate trends are "corrections", or offsetting movements in one direction after longer-term movements in another direction; trends lasting for the period described above are primary trends.

 21. A daily fluctuation of little importance is called ____________. A. a minor trendB. a primary trendC. an intermediate trendD. a market trendE. None of these is correct.

A daily fluctuation of little importance is called a minor trend.

 22. Price movements that are caused by short-term deviations of prices from the underlying trend line are called A. primary trends.B. secondary trends.C. tertiary trends.D. Dow trends.E. contrary trends.

The secondary trend is caused by these deviations, which are eliminated by corrections that bring the prices back to the trend lines.

 23. The Dow theory posits that the three forces that simultaneously affect stock prices are ____________. I) primary trendII) intermediate trendIII) momentum trendIV) minor trendV) contrarian trend A. I, II, and IIIB. II, III, and IVC. III, IV and VD. I, II, and IVE. I, III, and V

The Dow theory posits that the three forces that simultaneously affect stock prices are primary trend, intermediate trend, and minor trend.

 

24. The Elliot Wave Theory ____________. A. is a recent variation of the Dow TheoryB. suggests that stock prices can be described by a set of wave patternsC. is similar to the Kondratieff Wave theoryD. is a recent variation of the Dow Theory and suggests that stock prices can be described by a set of wave patternsE. is a recent variation of the Dow Theory, suggests that stock prices can be described by a set of wave patterns, and is similar to the Kondratieff Wave theory

Both the Elliot Wave Theory and the Kondratieff Wave Theory are recent variations on the Dow Theory, which suggests that stock prices move in identifiable wave patterns.

 25. A trin ratio of less than 1.0 is considered as a _________. A. bearish signalB. bullish signalC. bearish signal by some technical analysts and a bullish signal by other technical analystsD. bullish signal by some fundamentalistsE. bearish signal by some technical analysts, a bullish signal by other technical analysts and bullish signal by some fundamentalists

A trin ratio of less than 1.0 is considered bullish because the declining stocks have lower average volume than the advancing stocks, indicating net buying pressure.

 26. On October 29, 2009 there were 1,031 stocks that advanced on the NYSE and 610 that declined. The volume in advancing issues was 112,866,000 and the volume in declining issues was 58,188,000. The trin ratio for that day was ________ and technical analysts were likely to be ________. A. 0.87, bullishB. 0.87, bearishC. 1.15, bullishD. 1.15, bearishE. None of these is correct.

(1,031/610)/(112,866,000/58,388,000) = 0.87. A trin ratio less than 1 is considered bullish because advancing stocks have a higher volume than declining stocks, indicating a buying pressure.

 27. In regard to moving averages, it is considered to be a ____________ signal when market price breaks through the moving average from ____________. A. bearish; belowB. bullish; belowC. bearish; aboveD. bullish; aboveE. both bullish; below and bearish; above

In regard to moving averages, it is considered to be a bullish signal when market price breaks through the moving average from below. In addition, it is considered to be a bearish signal when market price breaks through the moving average from above.

 

28. Two popular moving average periods are A. 90-day and 52 weekB. 180-day and three yearC. 180-day two yearD. 200-day and 53 weekE. 200-day and two year

Two popular moving average periods are 200-day and 53 week.

 29. ____________ is a measure of the extent to which a movement in the market index is reflected in the price movements of all stocks in the market. A. Put-call ratioB. Trin ratioC. BreadthD. Confidence indexE. All of these are correct.

Breadth is a measure of the extent to which a movement in the market index is reflected in the price movements of all stocks in the market.

 30. Then confidence index is computed from ____________ and higher values are considered ____________ signals. A. bond yields; bearishB. odd lot trades; bearishC. odd lot trades; bullishD. put/call ratios; bullishE. bond yields; bullish

Then confidence index is computed from bond yields and higher values are considered bullish signals. 

31. The put/call ratio is computed as ____________ and higher values are considered ____________ signals. A. the number of outstanding put options divided by outstanding call options; bullish or bearishB. the number of outstanding put options divided by outstanding call options; bullishC. the number of outstanding put options divided by outstanding call options; bearishD. the number of outstanding call options divided by outstanding put options; bullishE. the number of outstanding call options divided by outstanding put options; bearish

The put/call ratio is computed as the number of outstanding put options divided by outstanding call options and higher values are considered bullish or bearish signals.

 

32. The efficient market hypothesis ____________. A. implies that security prices properly reflect information available to investorsB. has little empirical validityC. implies that active traders will find it difficult to outperform a buy-and-hold strategyD. has little empirical validity and implies that active traders will find it difficult to outperform a buy-and-hold strategyE. implies that security prices properly reflect information available to investors and implies that active traders will find it difficult to outperform a buy-and-hold strategy

The efficient market hypothesis implies that security prices properly reflect information available to investors and active traders will find it difficult to outperform a buy-and-hold strategy.

33. Tests of market efficiency have focused on ____________. A. the mean-variance efficiency of the selected market proxyB. strategies that have provided superior risk-adjusted returnsC. results of investments of professional managersD. strategies that have provided superior risk-adjusted returns and results of investments of professional managersE. the mean-variance efficiency of the selected market proxy and strategies that have provided superior risk-adjusted returns

Tests of market efficiency have focused on strategies that have provided superior risk-adjusted returns and results of investments of professional managers.

 34. The anomalies literature ____________. A. provides a conclusive rejection of market efficiencyB. provides conclusive support of market efficiencyC. suggests that several strategies would have provided superior returnsD. provides a conclusive rejection of market efficiency and suggests that several strategies would have provided superior returnsE. None of these is correct.

The anomalies literature suggests that several strategies would have provided superior returns.

 35. Behavioral finance argues that ____________. A. even if security prices are wrong it may be difficult to exploit themB. the failure to uncover successful trading rules or traders cannot be taken as proof of market efficiencyC. investors are rationalD. even if security prices are wrong it may be difficult to exploit them, and the failure to uncover successful trading rules or traders cannot be taken as proof of market efficiencyE. All of these are correct.

Behavioral finance argues that even if security prices are wrong it may be difficult to exploit them and the failure to uncover successful trading rules or traders cannot be taken as proof of market efficiency.

 

36. Markets would be inefficient if irrational investors __________ and actions if arbitragers were __________. A. existed; unlimitedB. did not exist; unlimitedC. existed; limitedD. did not exist; limitedE. None of these is correct.

Markets would be inefficient if irrational investors existed and actions if arbitragers were limited.

37. If prices are correct __________ and if prices are not correct __________. A. there are no easy profit opportunities; there are no easy profit opportunitiesB. there are no easy profit opportunities; there are easy profit opportunitiesC. there are easy profit opportunities; there are easy profit opportunitiesD. there are easy profit opportunities; there are no easy profit opportunitiesE. None of these is correct.

If prices are correct there are no easy profit opportunities and if prices are not correct there are no easy profit opportunities.

 38. __________ can lead investors to misestimate the true probabilities of possible events or associated rates of return. A. Information processing errorsB. Framing errorsC. Mental accounting errorsD. Regret avoidanceE. All of these are correct.

Information processing errors can lead investors to misestimate the true probabilities of possible events or associated rates of return.

 39. Kahneman and Tversky (1973) report that __________ and __________. A. people give too little weight to recent experience compared to prior beliefs; tend to make forecasts that are too extreme given the uncertainty of their informationB. people give too much weight to recent experience compared to prior beliefs; tend to make forecasts that are too extreme given the uncertainty of their informationC. people give too little weight to recent experience compared to prior beliefs; tend to make forecasts that are not extreme enough given the uncertainty of their informationD. people give too much weight to recent experience compared to prior beliefs; tend to make forecasts that are not extreme enough given the uncertainty of their informationE. None of these is correct.

Kahneman and Tversky (1973) report that people give too much weight to recent experience compared to prior beliefs and tend to make forecasts that are too extreme given the uncertainty of their information.

 

40. Errors in information processing can lead investors to misestimate __________. A. true probabilities of possible events and associated rates of returnB. occurrence of possible eventsC. only possible rates of returnD. the effect of accounting manipulationE. fraud

Errors in information processing can lead investors to misestimate true probabilities of possible events and associated rates of return.

 41. DeBondt and Thaler (1990) argue that the P/E effect can be explained by __________. A. forecasting errorsB. earnings expectations that are too extremeC. earnings expectations that are not extreme enoughD. regret avoidanceE. both forecasting errors and earnings expectations that are too extreme

DeBondt and Thaler (1990) argue that the P/E effect can be explained by forecasting errors and earnings expectations that are too extreme.

 42. Barber and Odean (2001) report that men trade __________ frequently than women and the frequent trading leads to __________ returns. A. less; superiorB. less; inferiorC. more; superiorD. more; inferiorE. None of these is correct.

Barber and Odean (2001) report that men trade more frequently than women and the frequent trading leads to inferior returns.

 43. Conservatism implies that investors are too __________ in updating their beliefs in response to new evidence and that they initially __________ to news. A. quick; overreactB. quick; under reactC. slow; overreactD. slow; under reactE. None of these is correct.

Conservatism implies that investors are too slow in updating their beliefs in response to new evidence and that they initially under react to news.

 

44. If information processing were perfect, many studies conclude that individuals would tend to make __________ decisions using that information due to __________. A. less-than-fully rational; behavioral biasesB. fully rational; behavioral biasesC. less-than-fully rational; fundamental riskD. fully rational; fundamental riskE. fully rational; utility maximization

If information processing were perfect, many studies conclude that individuals would tend to make less-than-fully rational decisions using that information due to behavioral biases.

 45. The assumptions concerning the shape of utility functions of investors differ between conventional theory and prospect theory. Conventional theory assumes that utility functions are __________ whereas prospect theory assumes that utility functions are __________. A. concave and defined in terms of wealth; s-shaped (convex to losses and concave to gains) and defined in terms of loses relative to current wealthB. convex and defined in terms of loses relative to current wealth; s-shaped (convex to losses and concave to gains) and defined in terms of loses relative to current wealthC. s-shaped (convex to losses and concave to gains) and defined in terms of loses relative to current wealth; concave and defined in terms of wealthD. s-shaped (convex to losses and concave to gains) and defined in terms of wealth; concave and defined in terms of loses relative to current wealthE. convex and defined in terms of wealth; concave and defined in terms of gains relative to current wealth

The assumptions concerning the shape of utility functions of investors differ between conventional theory and prospect theory. Conventional theory assumes that utility functions are concave and defined in terms of wealth whereas prospect theory assumes that utility functions are s-shaped (convex to losses and concave to gains) and defined in terms of loses relative to current wealth.

 46. The law-of-one-price posits that ability to arbitrage would force prices of identical goods to trade at equal prices. However, empirical evidence suggests that __________ are often mispriced. A. Siamese Twin CompaniesB. equity carve outsC. closed-end fundsD. both Siamese Twin Companies and closed-end fundsE. All of these are correct.

The law-of-one-price posits that ability to arbitrage would force prices of identical goods to trade at equal prices. However, empirical evidence suggests that Siamese Twin Companies, equity carve outs, and closed-end funds are often mispriced.

 

47. Kahneman and Tversky (1973) reported that people give __________ weight to recent experience compared to prior beliefs when making forecasts. This is referred to as __________. A. too little; hyper rationalityB. too little; conservatismC. too much; framingD. too much; memory biasE. None of these is correct.

Kahneman and Tversky (1973) reported that people give too much weight to recent experience compared to prior beliefs when making forecasts. This is referred to as memory bias.

 48. Kahneman and Tversky (1973) reported that __________ give too much weight to recent experience compared to prior beliefs when making forecasts. A. young menB. young womenC. peopleD. older menE. older women

Kahneman and Tversky (1973) reported that people give too much weight to recent experience compared to prior beliefs when making forecasts.

 49. Barber and Odean (2001) report that men trade __________ frequently than women. A. lessB. less in down marketsC. more in up marketsD. moreE. None of these is correct.

Barber and Odean (2001) report that men trade more frequently than women.

 50. Barber and Odean (2001) report that women trade __________ frequently than men. A. lessB. less in down marketsC. more in up marketsD. moreE. None of these is correct.

Barber and Odean (2001) report that men trade more frequently than women.

 

51. Barber and Odean (2001) report that men __________ than women. A. earn higher returnsB. earn lower returnsC. earn about the same returnsD. generate lower trading costsE. None of these is correct.

Barber and Odean (2001) report that men trade more frequently than women and have lower returns.

 

52. Barber and Odean (2001) report that women __________ than men. A. earn higher returnsB. earn lower returnsC. earn about the same returnsD. generate higher trading costsE. None of these is correct.

Barber and Odean (2001) report that men trade more frequently than women and have lower returns.

53. __________ effects can help explain momentum in stock prices. A. ConservatismB. Regret avoidanceC. Prospect theoryD. Mental accountingE. Model risk

Mental accounting effects can help explain momentum in stock prices.

 54. Studies of Siamese twin companies find __________ which __________ the EMH. A. correct relative pricing; supportsB. correct relative pricing; does not supportC. incorrect relative pricing; supportsD. incorrect relative pricing; does not supportE. None of these is correct.

Studies of Siamese twin companies find incorrect relative pricing which does not support the EMH.

55. Studies of equity carve-outs find __________ which __________ the EMH. A. strong support for the Law of One Price; supportsB. strong support for the Law of One Price; violatesC. evidence against the Law of One Price; violatesD. evidence against the Law of One Price; supportsE. None of these is correct.

Studies of equity carve-outs find evidence against the Law of One Price which violates the EMH.

 56. Studies of closed-end funds find __________ which __________ the EMH. A. prices at a premium to NAV; is consistent withB. prices at a premium to NAV; is inconsistent withC. prices at a discount to NAV; is consistent withD. prices at a discount to NAV; is inconsistent withE. both prices at a premium to NAV; is inconsistent with and prices at a discount to NAV; is inconsistent with

Studies of closed-end funds find prices at premiums and discounts to NAV which is inconsistent with the EMH.

 Short Answer Questions

 57. Compare and contrast the efficient market hypothesis with the school of thought termed behavioral finance. 

The efficient market hypothesis posits that investors are fully informed, rational, utility maximizers. Thus, security prices will fully reflect all information available to the investors. If any security becomes mispriced, the collective buying and selling actions of investors will quickly cause prices to change. Given an efficient market, it would be difficult to find a trading rule that would consistently outperform the market. Moreover, failure to uncover profitable trading strategies may be taken as proof of market efficiency. Behavioral finance argues that conventional theory ignores how real people make decisions and that people make a difference. Behavioral finance says that investors possess two "irrationalities". First, investors do not always process information correctly and secondly they often make systematically suboptimal decisions. Given less than perfectly rational investors, prices may be wrong and it still may be hard to exploit them. Thus, failure to uncover profitable trading strategies may not be taken as proof of market efficiency.

 58. Behavioral finance posits that investors possess information processing errors. Discuss the importance of information processing errors then list and explain the four information processing errors discussed in the text. 

Information processing errors are important because they can lead investors to misestimate the true probabilities of possible events or associated rates of return. The four information processing errors are forecasting errors, overconfidence, conservatism, and sample size neglect. Forecasting errors arise when people give too much weight to recent experience. This leads to forecasts that are too extreme. Overconfidence refers to traders believing that they are better than average. This belief that they are superior leads to frequent trading (and according to empirical evidence, lower returns). Conservatism refers investors being slow in responding to new information rather than acting immediately. Sample size neglect refers to investors ignoring the size of a sample and making inferences based on a small sample.

Feedback: This question tests the students understanding of information processing errors.

 59. Behavioral finance posits that investors possess behavioral biases. Discuss the importance of behavioral biases then list and explain the four behavioral biases discussed in the text. 

Behavioral biases are important because even if information processing was perfect, individuals may tend to make less-than-fully rational decisions using that information. The four behavioral biases are framing, mental accounting, regret avoidance, and prospect theory (or loss aversion). Framing refers to the tendency of investors to change preferences due to the way an investment is "framed" (i.e., in terms of risk or in terms of return). Mental accounting is a specific form of framing where an investor takes a lot of risk with one investment account but little risk with another account. Regret avoidance refers to the tendency of investors to blame themselves more for an unconventional investment that was unsuccessful than a conventional investment that was unsuccessful. Prospect theory (loss avoidance) suggests that the investor's utility curve is not concave and defined in terms of wealth. Instead, the investor's utility function would be defined in terms of losses relative to current wealth. Thus, the utility curve is convex to losses and concave to gains giving rise to an s-shaped utility curve.

Feedback: This question tests the students understanding of behavioral biases.

 60. Discuss what technical analysis is, what technical analysts do, and the relationship between technical analysis, fundamental analysis, and behavioral finance. 

Technical analysis attempts to exploit recurring and predictable patterns in stock prices to generate superior portfolio performance. To determine recurring patterns, technical analysts examine historical returns by means of charts and or time-series analysis (such as moving averages). Technical analysts do not deny fundamental analysis but believe that prices adjust slowly to new information. Therefore, the key is to exploit the slow adjustment to the correct new price when information is released. Technical analysts also use volume and other data to assess market sentiment in an attempt to ascertain the future direction of the market. Behaviorists believe that behavioral biases may be related to both price and volume data. Thus, technical analysis can be related to behavioral finance.

Feedback: This question tests the students understanding of technical analysis; and how technical analysis relates to fundamental analysis and behavioral finance.