Another example derives from the concept of representatives, 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 misprinting in the securities markets would buy underpinned 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 exalt 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 misprinting can get worse over time.
An example of this fundamental risk is the apparent ongoing overpricing of the NASDAQ index in the late 1 sass. A related factor is 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 mulching Is, In fact, a consequence of model risk; that is, the perceived misplacing may not be real because the Investor has used a faulty model to value the security. Ricers: 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. . Overconfidence or representatives). 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 misprinting of securities.
However, the behavioral finance literature generally does not provide audience 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.
Shrug 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 axis 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. 10. Underlying risks still exist even during a misprinting event.
The market misprinting could get worse before it gets better. Other adverse effects could occur before the price corrects itself (e. G. Loss of clients with no understanding or appetite or misprinting opportunities). 1 1 . Data mining is the process by which patterns are pulled from data. Technical analysts must be careful not to engage in data mining as great is the human capacity to discern patterns where no patterns exist. Technical analysts must avoid mining data to support a theory, rather than using data to test a theory. 12.
Even if prices follow a random walk, the existence of irrational investors combined with the limits to arbitrage by arbitrageurs may allow persistent mainsprings to be present. This implies that capital will not be allocated efficiently-? UAPITA does not immediately flow from relatively unproductive firms to relatively productive firms. 13. -urn – This train ratio, which is below 1. 0, would be taken as a bullish signal. 14. Breadth: Breadth is positive-?bullish signal (no one would actually use a one-day measure). 15. This exercise is left to the student; answers will vary. 6. The confidence index increases from (5%/6%) = 0. 833 to = 0. 857. This indicates slightly higher confidence which would be interpreted by technicians as a bullish signal. But the real reason for the increase in the index is the expectation of Geiger inflation, not higher confidence about the economy. 17. At the beginning of the period, the price of Computers, Inc. Divided by the industry index was 0. 39; by the end of the period, the ratio had increased to 0. 50. As the ratio increased over the period, it appears that Computers, Inc. Outperformed other firms in its industry.
