Problem set 12

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Dec 17, 2023 PROBLEM SET ASSIGNMENT 12 KINJAL DESAI FIN627 INVESTMENT MANAGEMENT Stevens Institute of Technology – Fall 2023

1 | P a g e CHAPTER : 12 Q.1: Explain how some of the behavioral biases discussed in the chapter might contribute to the success of technical trading rules? → Technical analysis is the process of looking for patterns or trends in market pricing. These trends are typically seen by technical analysts as momentum, as well as slow adjustments to "correct" pricing or, in the opposite case, trend reversals. → Several behavioral biases covered in this chapter may be responsible for these patterns and trends. For instance, as investors gradually consider new information, a conservatism bias may contribute to a price trend that eventually moves prices closer to their underlying values. → Another example comes from the idea of representativeness, which misleads investors into believing that a pattern has been identified that would persist for a very long time based on a tiny sample of data. Corrections reverse the initial false trend when investors realize later that prices have overreacted. Q.2: Why would an advocate of the efficient market hypothesis believe that even if many investors exhibit the behavioral biases discussed in the chapter, security prices might still be set efficiently? → Security prices may still be set efficiently even if many investors display behavioral biases if arbitrageurs force prices to return to their fundamental values. → When mispricing in the securities markets is observed, arbitrageurs will likely purchase underpriced securities or short sell overpriced securities to profit from the expected adjustments that occur when prices return to their intrinsic values. → As a result, securities prices would continue to display the traits of an efficient market. Q.3: What sorts of factors might limit the ability of rational investors to take advantage of any “pricing errors” that result from the actions of behavioral investors”? → The fact that mispricing might worsen over time is one of the main obstacles preventing rational investors from profiting from any "pricing errors" brought about by the conduct of behavioral investors. → The NASDAQ index's apparent continuous overpricing in the late 1990s is one illustration of this fundamental risk. The expenses and restrictions associated with short selling are related issues that limit the amount that arbitrage may compel expensive stocks (or indexes) to return to their fair values. → In addition, rational investors need to be mindful of the possibility that an apparent mispricing is a result of model risk — that is, that the perceived mispricing might not be accurate because the investor valued the security using an inaccurate model. Q.4: Even if behavioral biases do not affect equilibrium asset prices, why might it still be important for investors to be aware of them? → Behavioral biases may not influence equilibrium asset prices for two reasons: first, they may help technical trading rules succeed as prices progressively revert to their intrinsic values; second, arbitrageurs' actions may cause security prices to revert to their intrinsic values. Even if behavioral biases have no effect on

2 | P a g e equilibrium pricing, investors may still want to be aware of these biases because either of these scenarios could lead to the possibility of excess gains. → Additionally, to assist prevent some of these information processing problems (such as overconfidence or representativeness), an investor should be conscious of his own behavioral biases, even if those biases have little bearing on equilibrium pricing. Q.6: Jill Davis tells her broker that she does not want to sell her stocks that are below the price she paid for them. She believes that if she just holds on to them a little longer, they will recover, at which time she will sell them. What behavioral characteristic does Davis have as the basis for her decision making? a. Loss aversion. b. Conservatism. c. Representativeness. → The correct response is option a. → Davis bases her decisions on her dislike to loss. In the expectation that they will rise, she hangs onto equities that have dropped from the purchase price. She finds it difficult to accept defeat. Q.7: After Polly Shrum sells a stock, she avoids following it in the media. She is afraid that it may subsequently increase in price. What behavioral characteristic does Shrum have as the basis for her decision making? a. Fear of regret. b. Representativeness. c. Mental accounting. → The right response is A. → Shrum doesn't want to watch a stock after she sells it because she doesn't want to feel guilty when it rises. Her dread of regret serves as the behavioral trait that guides her decision-making. Q.8: All the following actions are consistent with feelings of regret except: a. Selling losers quickly. b. Hiring a full-service broker. c. Holding on to losers too long. → The right response is option a. → Holding onto losers in the hopes that the equities would rise is one-way investors try to avoid feeling bad. The stock can be sold without feeling guilty if it rises to its initial acquisition price. By engaging a full- service broker, investors might also attempt to distance themselves from their actions to avoid regret. Q.9: Match each example to one of the following behavioral characteristics. No. Example Characteristics a. Investors are slow to update their beliefs when given new evidence. i. Disposition effect.

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3 | P a g e b. Investors are reluctant to bear losses caused by their unconventional decisions. ii. Representativeness bias. c. Investors exhibit less risk tolerance in their retirement accounts versus their other stock accounts. iii. Regret avoidance. d. Investors are reluctant to sell stocks with “paper” losses. iv. Conservatism bias. e. Investors disregard sample size when forming views about the future from the past. v. Mental accounting. → a. iv → b. iii → c. v → d. i → e. ii Q.13: Use the data from The Wall Street Journal in Figure 12.5 to verify the trin ratio for the NYSE. Is the trin ratio bullish or bearish? → Trin = = 1.16 → This trin ratio, which is above 1.0, would be taken as a bearish signal. Q.14: Calculate breadth for the NYSE using the data in Figure 12.5. Is the signal bullish or bearish? advancing Number / advancing Volume declining Number / declining Volume

4 | P a g e → → Breadth is negative — bearish signal (no one would use a one-day measure). Q.19: Yesterday, the Dow Jones industrials gained 54 points. However, 1,704 issues declined in price while 1,367 advanced. Why might a technical analyst be concerned even though the market index rose on this day? → There is a lack of breadth in this pattern. Despite the index's increase, more stocks fell than rose, pointing to a "lack of broad-based support" for the index's climb. Q.24 (a): Go to www.mhhe.com/bkm and link to the material for Chapter 12, where you will find 5 years of weekly returns for the S&P 500 and Fidelity’s Select Banking Fund (ticker FSRBX). a. Set up a spreadsheet to calculate the relative strength of the banking sector compared to the broad market. Hint: As in the previous problem, set the initial value of the sector index and the S&P 500 index equal to 100, and use each week’s rate of retur n to update the level of each index. → We used a base of 100 for the week before the first week of the data set to convert the weekly returns for the S&P 500 and the Fidelity Banking Fund to weekly index values to produce the relative strength measure. The resultant values and the relative strength measure (× 100) are displayed in the first graph. The relative strength measure's percentage change across five-week periods is displayed in the second graph. → The fund's relative strength data is summarized in the graph below.

5 | P a g e Q.24 (b): Identify every instance in which the relative strength ratio increases by at least 5% from its value 5 weeks earlier. In how many of the weeks following a substantial increase in relative strength does the banking sector outperform the S&P 500? In how many of those weeks does the banking sector underperform the S&P 500? → The table and graph below show that relative strength grew by more than 5% 29 times over five-week intervals. In the weeks that followed a gain of more than 5%, the Fidelity Banking Fund underperformed the S&P 500 index 18 times and outperformed it 11 times. Date of Increase Performance of Banking Fund in Subsequent Week Date of Increase Performance of Banking Fund in Subsequent Week 07/21/00 Outperformed 03/09/01 Outperformed 08/04/00 Outperformed 03/16/01 Underperformed 08/11/00 Underperformed 03/30/01 Underperformed 08/18/00 Outperformed 06/22/01 Underperformed 09/22/00 Outperformed 08/17/01 Underperformed 09/29/00 Underperformed 03/15/02 Outperformed 10/06/00 Underperformed 03/22/02 Underperformed 12/01/00 Underperformed 03/28/02 Outperformed 12/22/00 Underperformed 04/05/02 Outperformed 12/29/00 Outperformed 04/12/02 Underperformed 01/05/01 Underperformed 04/26/02 Outperformed 01/12/01 Underperformed 05/03/02 Underperformed 02/16/01 Underperformed 05/10/02 Underperformed 02/23/01 Outperformed 06/28/02 Underperformed 03/02/01 Underperformed

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6 | P a g e Q.24 (c): Identify every instance in which the relative strength ratio decreases by at least 5% from its value 5 weeks earlier. In how many of the weeks following a substantial decrease in relative strength does the banking sector underperform the S&P 500? In how many of those weeks does the banking sector outperform the S&P 500? → The graph above and table below show that relative strength drops by more than 5% fifteen times during five-week periods. In the weeks that followed a drop of more than 5%, the Fidelity Banking Fund underperformed the S&P 500 index six times and beat it nine times. Q.24 (d): How well does the relative strength rule perform in identifying buy or sell opportunities? → Relative strength increasing, like in part (b) above, is considered a positive signal. In contrast, the Fidelity Banking Fund is more likely in our sample to underperform the S&P 500 index after receiving such a signal than to outperform the index. → Relative strength declining, like in component (c), is interpreted as a bearish signal. The Fidelity Banking Fund is more likely to surpass the index increase following a bearish signal in our sample than it is to underperform. Date of Decrease Performance of Banking Fund in Subsequent Week Date of Decrease Performance of Banking Fund in Subsequent Week 07/07/00 Underperformed 04/16/04 Underperformed 07/14/00 Outperformed 04/23/04 Outperformed 05/04/01 Underperformed 12/03/04 Outperformed 05/11/01 Outperformed 12/10/04 Underperformed 10/12/01 Outperformed 12/17/04 Outperformed 11/02/01 Outperformed 12/23/04 Underperformed 10/04/02 Outperformed 12/31/04 Underperformed 10/11/02 Outperformed

7 | P a g e