Chap9 - Chapter 09 - Behavioral Finance and Technical...

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Chapter 09 - Behavioral Finance and Technical Analysis CHAPTER 09 BEHAVIORAL FINANCE AND TECHNICAL ANALYSIS 1. Note the following matches Disposition effect – d Representativeness bias – e Regret avoidance – b Conservatism bias – a Mental accounting - c 2. Representativeness bias. The sample size is not considered when making future decisions. 3. Fundamental risk means that even if a security is mispriced, it still can be risky to attempt to exploit the mispricing. This limits the actions of arbitrageurs who take positions in mispriced securities. Thus, the bias may persist since no one takes advantage of it. 4. The premise of behavioral finance is that conventional financial theory ignores how real people make decisions and that people make a difference. Behavioral finance may site examples of market inefficiencies, but they give no insight into how to exploit such phenomenon. The strength of their argument relies upon observed market inefficiencies and unexplained market behavior. There are many anomalies, yet many can be reverse engineered or explained. Also, while anomalies exist, they rarely meet the test of statistical significance. 5. An unfortunate consequence of behavioral finance (BF) is a tendency for investors to assume more than actually is claimed by the field. While BF is highly critical of EMH and claims to offer alternative theories, it does not propose to be a predictor of future returns. Investors should be wary of people purporting to offer excess returns under the façade of BH. Such claims are likely to be false. 6. Statement b, that a price has moved above its 52 week moving average is considered a bullish sign. 7. After the fact, you can always find patterns and trading rules that would have generated enormous profits. This is called data mining. For technical analysts, this is a problem since they rarely can be reproduced to predict future profits. 8. Grinblatt and Han (2005) show that the disposition effect can lead to momentum in stock prices even if fundamental values follow a random walk. This momentum may not lead to abnormal profits, but may cause capital to flow to investments that appear to benefit from the momentum, in contrast to where it would otherwise flow. 9-1
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Chapter 09 - Behavioral Finance and Technical Analysis 9. Arbitrage assumes the ability to initiate trades based on arbitrage information. A severe limit of the theory is that similar assets should be priced similarly (Law of one price). An example of a limit in which such a trade is not possible is the case of Royal Dutch Petroleum and Shell. This is a case of “Siamese twin” companies, where the value was not proportional to the profit distribution. Attempts to profit from the incorrect pricing would result in substantial loss. An equity carve out is another example. In this, the sale of a portion of the company does not necessarily generate the exact percentage one would expect based on the percentage taken from the original company. The last example involved closed end funds that typically sell for less than NAV.
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Chap9 - Chapter 09 - Behavioral Finance and Technical...

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