Behavioral Finance

Question 1

Moving Averages

Answer 1

• buy stock when stock goes above moving average - Fundamentalists argue this approach is wrong - Patterns are not predictable enough - Technicians disagree saying Fundamentalists just dont know how to use them right - only way to see who is “right” is try this method out - effectiveness is different for each person

Question 2

Random Walks and efficient markets

Answer 2

• the theory that stock price and movements are upredictable, so there is no way to know where prices are headed

Question 3

Efficient Market Hypothesis

Answer 3

• Markets have a large number of knowledgable investors who react quickly to new information, causing securities prices to adjust quickly and accurately and since the market follows a random walk there is not way to earn an excess of market returns

Question 4

Weak Form of Eff. Market

Answer 4

• past data on stock prices are of no use in predicting future stock price changes- so technical analysis doesn’t work, the technicians of the world are not going to outperform the market

Question 5

Semi Strong From of Eff. Market

Answer 5

• Abnormally large profits cannot be consistently earned using public information - neither techinical or fundamental analysis will help - any price anomalies are quickly found out and the stock market adjusts

Question 6

Strong Form Eff. Market

Answer 6

• there is no information, public or private that will allow you to earn abnormally high profits - insiders can beat the market - following the insiders can help and following buyers is more helpful than following sellers

Question 7

Market Anomalies

Answer 7

• things that might work even if the market is random

Question 8

Calender Effects

Answer 8

• stock returns may be closely tied to the time of year or time of week - January Effect, If January is up, then the year will be up

Question 9

Small Firm Effect

Answer 9

• size of the firm tends to have an impact, small firms do seem to outperform large firms, even when you adjust for risk - small firms are riskier, return can be larger

Question 10

Earnings Announcments

Answer 10

• stock price adjustments may continue afte3r earnings adjustments have been announced - usually or unexpectedly good earnings may signal buying oppurtunity

Question 11

P/E Effect

Answer 11

Low P/E stocks may outperform high P/E stocks, even after adjusting risk

Question 12

Psychology and Investing

Answer 12

• stupid things people do in the market, and how we can benefit

Question 13

Financial Decision Making Assumptions

Answer 13

1. People make rational decisions 2. People are unbiased in predicting the future

Question 14

Percention of Risk

Answer 14

• in a state of constant flux - willingness to accept a risk depends on our mood - some people are willing to accept risk more than others (risk averse)

Question 15

Risk Framing

Answer 15

• how we frame risk affects our attitude - Example. - 75% lean meat, 25% fat, both burgers are the same but wont be percieved the same - wording is important (people see word fat and are alarmed) - 75% fat free is perceived better than 25% fat

Question 16

Overconfidence in Investing

Answer 16

• we tend to be overconfident, example. - most new businesses fail, but new business owners said that they had a 70% of succeeding - Overconfident investors tend to trade too much,take more risks - overconfidence increases as our knowledge increases

Question 17

Fear

Answer 17

• we are most often afraid of the least likely dangers - a market crash makes stocks cheaper but less likely to buy

Question 18

Pride and Regret

Answer 18

• avoiding regret and seeking pride affects our behavior - regret stronger emotion than pride - when you sell a loser there are two losses: financial and pyschological - anticipation of a loss has just as much on the brain as the actual loss - anticipation of a loss may drive us from making riskier investments (investing too safely)

Question 19

Pride and Regret Implications

Answer 19

• we sell winners too early - ride losers too long “Im just going to wait till it goes back up”

Question 20

Considering the Past

Answer 20

-When you win you are more likely to keep playing -Winning makes you more willing to accept risk - Be careful about thinking about past victories - Memory of the past tends to be skewed toward the positive (Overestimating

Question 21

Represntatives and Familiarity

Answer 21

• Company X is a good company- therefore company X is a good investment? not the case sometimes because it might be too expensive to get a good return - People prefer the familiar: - we are drawn to companies that we know and avoid stocks in another region or ones that are not recognizable names (should avoid this behavior)

Question 22

Social Interacting and Investing

Answer 22

• You’re success depends on the friends you keep - what do they discuss and in what do they invest? - Our tendency to herd magnifies psychological biases

Question 23

Conclusions and Recommendations

Answer 23

• success in the market involves a certain amount of self control - develop strategies to beat biases: - understand the biases - know why you are investing- have specific goals - diversify - check your stocks once a month - trade on the same day of each month or develop a plan to restrain your emotions - review your portfolio annually

Question 24

Emotions in Investing

Answer 24

• our feelings can be dangerous - good or bad moods will increase or decrease our willingness to take risks - optimistic people are greater risk takers