FINA Chapter 6 HW

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Chapter 6 HW 1. Identify and explain historical examples of decision making under uncertainty and the errors made by historical investors. Investors throughout history have tended to discount unfavorable outcomes, were overconfident and suffered from biased expectations and most like were subject to framing issues. History is littered with investment manias. Examples of bubbles include the UK railroad industry in the 1840s, the Japanese stock market in the early 1980s, the US stock market in 1929 and 1987, dot- com stocks in the late 1990s, and the housing market in 2008. Emotions and cognitive errors played huge roles in both the rise and fall of asset prices. 2. Discuss the development of modern portfolio theory and explain the fundamental principles on which it is based. In 1952 Harry Markowitz outlined how standard deviation could be used to measure on asset’s risk. Using investable assets’ expected returns, standard deviations and covariances with other assets, he then demonstarted how efficient portfolios that minimized risk for a given level of return could be identified. This formed the basis for modern portfolio theory. 3. Discuss the efficient market hypothesis and identify the three levels of market efficiency. The efficient market hypothesis proposed by Fama identified three information sets that are reflected in asset prices. He also suggests that changes in relevant information will be immediately and completely reflected in changing asset prices. Fama divided markets into three levels or degrees of information efficiency: weak form, semi-strong form, strong form (efficiency). 4. Explain the difference among weak form, semi-strong form, and strong form market efficiency. The weak form is when market prices are functions of historical prices and volume data. Semi- strong form is when market prices are functions of publicly available information (includes first data set). Strong form is when market prices are functions of all relevant information (which includes private first and second data sets). 5. Identify and discuss well-known stock market anomalies. Well-known stock market anomalies are the January Effect, Dogs of the Dow, Low Price to Book Value, and Neglected Firm Effect. The January Effect is a stock market phenomenon where investors buy stocks in late December and sell them in early January, leading to higher returns, often explained by tax-related motivations. The Dogs of the Dow strategy involves investing in the highest dividend-yielding stocks in the Dow Jones Industrial Average, historically resulting in outperformance of the overall Dow Index, with these stocks often being among the lower-priced ones in the index. Low price-to-book value stocks have demonstrated outperformance in numerous studies, but the challenge lies in their sensitivity to the definition of book value, with varying time periods favoring either total assets or tangible assets as the key metric. The Neglected Firm Effect suggests that smaller, less-analyzed companies with lower visibility and fewer outstanding shares tend to outperform over time as they grow.

6. Define behavioral finance and compare it to traditional finance. Behavorial finance has been investigated by many who focus not on the outcomes of decisions made by perfectly informed investors, but on the decision-making process itself, and its links to political science, sociology, and psychology. Traditional finance has rational investors who value securities rationally, investors possess perfect complete information, investors act in their own self-interest and never make mistakes, investors seek to maximize expected utility, arbitrage opportunities are not available, new information gets priced according to Bayes’ Rule, and investors are risk averse. Behavioral investors value securities heuristically, investors process incomplete information, investors act in their own self-interest, but make cognitive errors and have emotional biases, investors seek to minimize regret, arbitrage available because of bounded rationality, new information not immediately and completely priced, investors are loss averse. 7. List important behavioral finance assumptions. Decision makers are not perfectly rational agents and they exibit bounded rationality. Investors are easily influenced by their peers. Investor's view gains and losses differently from each other and their decisions are characterized by prospect theory. Investors make information processing errors that result in over reaction and under reaction to information changes. Investors make processing errors. Investors are emotional. 8. Discuss the concept of framing and how it explains the equity premium puzzle. Framing, in the context of finance and behavioral economics, refers to the way information is presented or "framed" can significantly influence people's decisions and perceptions. It's a concept that helps explain the equity premium puzzle, which is the phenomenon where stocks or equities tend to provide higher returns than less risky investments like bonds over the long term, despite the higher volatility and risk associated with stocks. 9. Explain prospect theory and how behavioral decision makers estimate the probability of future events. Prospect theory is a psychological theory developed by Daniel Kahneman and Amos Tversky in the 1970s that explains how people make decisions involving uncertainty and risk. It challenges the traditional economic assumption that individuals are perfectly rational and consistently make decisions based on expected utility theory. Prospect theory provides insights into how behavioral decision makers estimate the probability of future events and make choices in uncertain situations. 10. Explain how behavioral investors process information in the context of bounded rationality In the context of behavioral finance, bounded rationality refers to the idea that individuals have cognitive limitations that restrict their ability to process and analyze information fully. Behavioral investors often make decisions under these constraints, leading to deviations from what traditional finance theories would predict.

11. Define cognitive errors. Cognitive errors, also known as cognitive biases or cognitive distortions, are systematic patterns of deviation from norm or rationality in judgment and decision-making. These biases represent a departure from ideal or logical thinking and can lead individuals to make decisions or draw conclusions that are inconsistent with available evidence or objective reality. 12. List common cognitive errors. Confirmation bias, anchoring and adjustment, overconfidence bias, and hindsight bias are just a few common cognitive errors most frequently made. 13. Discuss how representativeness can lead to poorly managed portfolios. Representativeness is a cognitive bias in which individuals make decisions or judgments based on how well an event or entity represents a particular category or prototype, rather than considering objective statistical probabilities. In the context of portfolio management, the representativeness bias can lead to poorly managed portfolios in several ways 14. Define anchoring and discuss anchoring in the context of the Dow Jones Industrial Average surpassing 10,000, 20,000, and 30,000 levels. Anchoring is a cognitive bias that refers to the tendency of individuals to rely too heavily on the first piece of information they receive (the "anchor") when making decisions or judgments. Subsequent decisions are then often adjusted relative to this initial anchor, even if the anchor is arbitrary or irrelevant. When DJIA passes 10,000, people usually see this as a reference point, and use it for future judgements on stock performance. When it passes 20,000, people may see this as stock market doing well, and can influence decisions. If the DJIA crosses 30,000 after being anchored at 20,000, some individuals may be slow to recognize new market trends or may underestimate the potential for market corrections because they are anchored to the previous level. 15. Provide an example of mental accounting and discuss the consequences of this cognitive error. An example of expensive accounting is Bob, a financial analyst, who receives a 5,000$ bonus from the company due to a good profit year. Bobs immediate thought process to receiving his bonus can immediately begin to lose its structure. He automatically thinks about wasting his bonus cash on a luxury get away to Hawaii with his wife. He could have used his bonus to save up for future events like taxes and payments. He also misses the opportunity to obtain more cash by investing. 16. Provide examples of both confirmation and hindsight biases. For confirmation biased, an investor who believes that a specific stock is a great investment might only pay attention to news or analysis that supports their positive outlook on that stock. They might ignore warning signs or negative information, leading to potentially poor investment decisions. For Hindsight Biased, an individual may claim they predicted a market crash after it has happened, saying something like, "I saw it coming all along." In reality, they might not have taken any significant actions to protect their investments before the crash.

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17. Discuss how cognitive errors are violations of modern portfolio theory. Cognitive errors can cause investors to deviate from the principles of Modern Portfolio Theory, leading to suboptimal investment decisions. MPT relies on rational, data-driven decision-making, but cognitive biases can introduce emotional and behavioral factors that disrupt this process. Overconfidence Bias, Loss Aversion, Anchoring Bias, Confirmation Bias, and Herd Mentality are examples. 18. Summarize the reason loss aversion is regularly exhibited by some investors. Loss aversion is regularly exhibited by some investors due to a psychological bias rooted in the way humans perceive and react to gains and losses. loss aversion manifests as investors being overly cautious and risk averse. They are more likely to make conservative choices and may avoid investments with even moderate levels of risk, as they fear the emotional distress that comes with experiencing losses. This can lead to suboptimal portfolio construction, as investors may miss out on opportunities for higher returns associated with riskier assets. 19. Contrast loss aversion with regret aversion. While both loss aversion and regret aversion involve aversion to negative outcomes, loss aversion primarily concerns the fear of losing what one already has and often leads to risk-averse behavior, while regret aversion focuses on the fear of making a decision that might lead to future regret, potentially resulting in inaction or conservative decision-making to avoid regret. 20. Discuss why investors tend to be overconfident. Investors tend to be overconfident due to a significant behavioral bias where they overestimate their capacity to identify mispriced securities and place undue trust in their research on specific assets. This overconfidence bias extends beyond mere individual errors in security selection, primarily revolving around the gap between an investor's perceived knowledge and the actual state of information. Interestingly, overconfidence is more pronounced in experts, but it can affect anyone making financial decisions. This bias leads to undiversified portfolios, excessive risk-taking, and overly optimistic return expectations, as overconfident investors believe they possess a unique ability to discover low-risk, high-return securities, ultimately discounting the actual risks associated with their investments. 21. Review self-control and optimism biases and explain why each mishandles risk assessment. Self-control bias involves investors' inability to restrain their trading activity, often leading them to deviate from their long-term investment goals. This bias mishandles risk assessment because it causes individuals to engage in impulsive trading decisions, potentially increasing transaction costs and undermining the benefits of a well-structured, long-term investment strategy. On the other hand, the optimism bias mishandles risk assessment by making investors overly optimistic about their investments. This bias can cause them to underestimate or even ignore potential downside risks, focusing too heavily on positive outcomes. Ultimately, both biases hinder a balanced and realistic evaluation of risk in investment decisions, potentially leading to suboptimal investment outcomes.

22. Discuss how emotional biases are violations of modern portfolio theory. Emotional biases indeed represent significant violations of modern portfolio theory. This theory assumes that investors are rational, objective decision-makers, essentially devoid of emotional attachments or biases. It posits that investment decisions should be driven solely by risk and return considerations. However, behavioral investors, being human, inherently grapple with emotional influences that can distort their decision-making processes. Emotional biases such as fear, greed, overconfidence, and loss aversion can lead to subjective and often irrational choices, deviating from the theory's core assumption of purely rational, emotionless investors. These biases introduce unpredictability and subjectivity into the investment process, fundamentally contradicting the theory's principles of efficiency, diversification, and objective decision-making. 23. Describe how money managers exhibit behavioral investing characteristics. Money managers often exhibit behavioral investing characteristics consistent with prospect theory, as they are not immune to the influence of emotional and cognitive factors in their decision-making processes. They tend to be loss-averse, striving to make choices that minimize feelings of regret, which can lead them to be cautious in their investment decisions and more inclined to hold onto losing positions longer than warranted. Additionally, money managers may forecast in the presence of various biases, such as overconfidence and anchoring, which can affect their judgment of asset valuations and market trends. They may also identify decision points using naive expectations, sometimes relying on simplistic or overly optimistic assumptions about market behavior and asset performance. These behavioral traits can impact their portfolio management strategies and investment outcomes. 24. Explain how lesser known emotional biases, such as clustering illusion and irrational escalation, affect portfolio performance. Lesser-known emotional biases like the clustering illusion and irrational escalation can significantly impact portfolio performance. The clustering illusion can lead investors to make short-term, momentum-driven decisions, causing them to chase trends that may not persist, resulting in buying at inflated prices and selling during downturns. This can lead to suboptimal timing of trades and reduced returns. Similarly, irrational escalation can cause investors to double down on losing investments, ignoring contradictory evidence, which can result in larger losses and diminished portfolio diversification. In both cases, these emotional biases can undermine rational, long-term investment strategies and lead to poor portfolio outcomes. 25. Explain the existence of asset bubbles in the context of behavioral finance. Asset bubbles can be explained in the context of behavioral finance by highlighting the role of investor emotions and cognitive biases. In these situations, investors often exhibit herd behavior, driven by fear of missing out and a desire to conform to market trends. They tend to overvalue assets due to overconfidence and ignore fundamental valuations, leading to price disconnects from intrinsic value. As these bubbles inflate, the fear of missing out intensifies, creating a self- reinforcing cycle, until reality sets in, and the bubble bursts, often due to a sudden realization of overvaluation and a rush to sell.

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Question 5 Which is the single biggest reason stock price opinions differ wildly? Differing computing power of supercomputers in big banks that set the market O Different models to account for available information Behavioral finance (investor irrationality) O None of the above, stock price opinions do not differ from investor to investor Different access to information (market inefficiency)

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History suggests that all stock market bubbles will eventually pop and cause severe financial loss for many of those who purchased stock. Given this history, do you think that stock market bubbles will continue to occur? Why or why not?

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a. “Financial intermediaries play a crucial role in an economic crisis–they are responsible for both causing the market to crash and then helping it recover from the crisis.” Is this statement true? Discuss with an example.b. What are the risks and rewards of investing in the stock market as compared to the bond market?

8. The efficient markets hypothesis True or False: The efficient markets hypothesis holds only if all investors are rational. O False O True Almost all financial theory and decision models assume that the financial markets are efficient. The informational efficiency of financial markets determines the ability of investors to "beat" the market and earn excess (or abnormal) returns on their investments. If the markets are efficient, they will react rapidly as new relevant information becomes available. Financial theorists have identified three levels of informational efficiency that reflect what information is incorporated in stock prices. Identify the form of capital market efficiency under the efficient market hypothesis described in the following statement: Current market prices reflect all relevant information, whether it is known publicly or privately. This statement is consistent with: O Semistrong form efficiency O Strong form efficiency O Weak form efficiency

Question 1 Part A. What are the two key assumptions of the efficient market hypothesis?I. Rational investors collect information and compete for profitsII. Any temporary mispricing would be arbitraged away III. Irrationality: Investors make mistakes when forming expectations or making investment decisionsIV. The mispricing might not be quickly eliminated because of limits to arbitrage a) I and II b) II and IV c) III and IV d) I and III Part B. What are the two key assumptions of behavioral asset pricing theory?I. Rational investors collect information and compete for profitsII. Any temporary mispricing would be arbitraged away III. Irrationality: Investors make mistakes when forming expectations or making investment decisionsIV. The mispricing might not be quickly eliminated because of limits to arbitrage a) II and IV b) I and III c) III and IV d) I and II

Due to an unexpected pandemic, the uncertainty levels have gone up tremendously in the financial markets. Among other things, this increased uncertainty would cause the market value ratios to increase. Group of answer choices True False

a. "Financial intermediaries play a crucial role in an economic crisis-they are responsible for both causing the market to crash and then helping it recover from the crisis." Is this statement true? Discuss with an example. b. What are the risks and rewards of investing in the stock market as compared to the bond market?

Statement 1: Fundamental analysis believe that the historical performance of the stocks and markets areindications of future performanceStatement 2: Fundamental analysis works best in determining market sentiment and factor in the creation ofinvestment or trading decisionsStatement 3: Fundamental analysis will succeed if the analyst finds overlooked data in identifying undervaluedsecuritiesStatement 4: Fundamental analysis works best if all investors are logical and could separate emotions frominvestment decision.Statement 5: Fundamental analysis use charts and patterns that can suggest future activity and to measure asecurity’s intrinsic value.a. Only statements 1 and 3 are correct b. Only statements 2 and 4 are correct c. Only statements 1 and 2 are correct d. Only statements 3 and 4 are correct

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Which of the following is inconsistent or unrelated with the efficient market hypothesis? a. Changes in stock prices are impossible to predict from public information. b. Asset prices reflect all publicly available information about the value of the assets. c. Stock prices follow a random walk, so stock price movements should be impossible to predict. d. The stock market moves based on the changing animal spirits of investors. e. The stock market is informationally efficient. f. It is impossible to systematically beat the market

Stock prices in an inefficient market tend to adjust faster to the new public information. Select one: OTrue O False

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