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CHAPTER 12: BEHAVIORAL FINANCE AND TECHNICAL ANALYSISCHAPTER 12: BEHAVIORAL FINANCE
AND TECHNICAL ANALYSIS
PROBLEM SETS
1. Technical analysis can generally be viewed as a search for trends or patterns in
market prices. Technical analysts tend to view these trends as momentum, or
gradual adjustments to ‘correct’ prices, or, alternatively, reversals of trends. A
number of the behavioral biases discussed in the chapter might contribute to such
trends and patterns. For example, a conservatism bias might contribute to a trend
in prices as investors gradually take new information into account, resulting in
gradual adjustment of prices towards their fundamental values. Another example
derives from the concept of representativeness, which leads investors to
inappropriately conclude, on the basis of a small sample of data, that a pattern has
been established that will continue well into the future. When investors
subsequently become aware of the fact that prices have overreacted, corrections
reverse the initial erroneous trend.
2. Even if many investors exhibit behavioral biases, security prices might still be set
efficiently if the actions of arbitrageurs move prices to their intrinsic values.
Arbitrageurs who observe mispricing in the securities markets would buy
underpriced securities (or possibly sell short overpriced securities) in order to profit
from the anticipated subsequent changes as prices move to their intrinsic values.
Consequently, securities prices would still exhibit the characteristics of an efficient
market.
3. One of the major factors limiting the ability of rational investors to take advantage
of any ‘pricing errors’ that result from the actions of behavioral investors is the fact
that a mispricing can get worse over time. An example of this fundamental risk is
the apparent ongoing overpricing of the NASDAQ index in the late 1990s. Related
factors are the inherent costs and limits related to short selling, which restrict the
extent to which arbitrage can force overpriced securities (or indexes) to move
towards their fair values. Rational investors must also be aware of the risk that an
apparent mispricing is, in fact, a consequence of model risk; that is, the perceived
mispricing may not be real because the investor has used a faulty model to value the
security.
12-1
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
, CHAPTER 12: BEHAVIORAL FINANCE AND TECHNICAL ANALYSIS
4. There are two reasons why behavioral biases might not affect equilibrium asset
prices: first, behavioral biases might contribute to the success of technical trading
rules as prices gradually adjust towards their intrinsic values, and second, the
actions of arbitrageurs might move security prices towards their intrinsic values. It
might be important for investors to be aware of these biases because either of these
scenarios might create the potential for excess profits even if behavioral biases do
not affect equilibrium prices.
In addition, an investor should be aware of his personal behavioral biases, even if
those biases do not affect equilibrium prices, to help avoid some of these
information processing errors (e.g. overconfidence or representativeness).
5. Efficient market advocates believe that publicly available information (and, for
advocates of strong-form efficiency, even insider information) is, at any point in
time, reflected in securities prices, and that price adjustments to new information
occur very quickly. Consequently, prices are at fair levels so that active
management is very unlikely to improve performance above that of a broadly
diversified index portfolio. In contrast, advocates of behavioral finance identify a
number of investor errors in information processing and decision making that could
result in mispricing of securities. However, the behavioral finance literature
generally does not provide guidance as to how these investor errors can be exploited
to generate excess profits. Therefore, in the absence of any profitable alternatives,
even if securities markets are not efficient, the optimal strategy might still be a
passive indexing strategy.
6. a. Davis uses loss aversion as the basis for her decision making. She holds on to
stocks that are down from the purchase price in the hopes that they will recover.
She is reluctant to accept a loss.
7. a. Shrum refuses to follow a stock after she sells it because she does not want to
experience the regret of seeing it rise. The behavioral characteristic used for the
basis for her decision making is the fear of regret.
8. a. Investors attempt to avoid regret by holding on to losers hoping the stocks will
rebound. If the stock rebounds to its original purchase price, the stock can be sold
with no regret. Investors also may try to avoid regret by distancing themselves from
their decisions by hiring a full-service broker.
12-2
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
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