Multiple Choice Questions 1.

Conventional theories presume that investors ____________ and behavioral finance presumes that they ____________. A) are irrational; are irrational B) are rational; may not be rational C) are rational; are rational D) may not be rational; may not be rational E) may not be rational; are rational Answer: B Difficulty: Easy 2. The premise of behavioral finance is that A) conventional financial theory ignores how real people make decisions and that people make a difference. B) conventional financial theory considers how emotional people make decisions but the market is driven by rational utility maximizing investors. C) conventional financial theory should ignore how the average person makes decisions because the market is driven by investors that are much more sophisticated than the average person. D) B and C E) none of the above Answer: A Difficulty: Easy 3. Some economists believe that the anomalies literature is consistent with investors ____________ and ____________. A) ability to always process information correctly and therefore they infer correct probability distributions about future rates of return; given a probability distribution of returns, they always make consistent and optimal decisions B) inability to always process information correctly and therefore they infer incorrect probability distributions about future rates of return; given a probability distribution of returns, they always make consistent and optimal decisions C) ability to always process information correctly and therefore they infer correct probability distributions about future rates of return; given a probability distribution of returns, they often make inconsistent or suboptimal decisions D) inability to always process information correctly and therefore they infer incorrect probability distributions about future rates of return; given a probability distribution of returns, they often make inconsistent or suboptimal decisions E) none of the above Answer: D Difficulty: Moderate

4. Information processing errors consist of I) II) III) IV) A) B) C) D) E) forecasting errors overconfidence conservatism framing

I and II I and III III and IV IV only I, II and III

Answer: E Difficulty: Moderate 5. Forecasting errors are potentially important because A) research suggests that people underweight recent information. B) research suggests that people overweight recent information. C) research suggests that people correctly weight recent information. D) either A or B depending on whether the information was good or bad. E) none of the above. Answer: B Difficulty: Moderate 6. DeBondt and Thaler believe that high P/E result from investors A) earnings expectations that are too extreme. B) earnings expectations that are not extreme enough. C) stock price expectations that are too extreme. D) stock price expectations that are not extreme enough. E) none of the above. Answer: A Difficulty: Moderate 7. If a person gives too much weight to recent information compared to prior beliefs, they would make ________ errors. A) framing B) selection bias C) overconfidence D) conservatism E) forecasting Answer: E Difficulty: Moderate

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8. Single men trade far more often than women. This is due to greater ________ among men. A) framing B) regret avoidance C) overconfidence D) conservatism E) none of the above Answer: C Difficulty: Moderate 9. ____________ may be responsible for the prevalence of active versus passive investments management. A) Forecasting errors B) Overconfidence C) Mental accounting D) Conservatism E) Regret avoidance Answer: B Difficulty: Moderate 10. Barber and Odean (2000) ranked portfolios by turnover and report that the difference in return between the highest and lowest turnover portfolios is 7% per year. They attribute this to A) overconfidence B) framing C) regret avoidance D) sample neglect E) all of the above Answer: A Difficulty: Moderate 11. ________ bias means that investors are too slow in updating their beliefs in response to evidence. A) framing B) regret avoidance C) overconfidence D) conservatism E) none of the above Answer: D Difficulty: Moderate

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12. Psychologists have found that people who make decisions that turn out badly blame themselves more when that decision was unconventional. The name for this phenomenon is A) regret avoidance B) framing C) mental accounting D) overconfidence E) obnoxicity Answer: A Difficulty: Moderate Rationale: An investments example given in the text is buying the stock of a start-up firm that shows subsequent poor performance, versus buying blue chip stocks that perform poorly. Investors tend to have more regret if they chose the less conventional start-up stock. DeBondt and Thaler say that such regret theory is consistent with the size effect and the book-to-market effect. 13. An example of ________ is that a person may reject an investment when it is posed in terms of risk surrounding potential gains but may accept the same investment if it is posed in terms of risk surrounding potential losses. A) framing B) regret avoidance C) overconfidence D) conservatism E) none of the above Answer: A Difficulty: Moderate 14. Statman (1977) argues that ________ is consistent with some investors' irrational preference for stocks with high cash dividends and with a tendency to hold losing positions too long. A) mental accounting B) regret avoidance C) overconfidence D) conservatism E) none of the above Answer: A Difficulty: Moderate

Chapter 12 Behavioral Finance and Technical Analysis

15. An example of ________ is that it is not as painful to have purchased a blue-chip stock that decreases in value, as it is to lose money on an unknown start-up firm. A) mental accounting B) regret avoidance C) overconfidence D) conservatism E) none of the above Answer: B Difficulty: Moderate 16. Arbitrageurs may be unable to exploit behavioral biases due to ____________. I) II) III) IV) V) A) B) C) D) E) fundamental risk implementation costs model risk conservatism regret avoidance

I and II only I, II, and III I, II, III, and V II, III, and IV IV and V

Answer: B Difficulty: Moderate 17. ____________ are good examples of the limits to arbitrage because they show that the law of one price is violated. I) II) III) IV) V) A) B) C) D) E) Siamese Twin Companies Unit trusts Closed end funds Open end funds Equity carve outs

I and II I, II, and III I, III, and V IV and V V

Answer: C Difficulty: Moderate

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18. __________ was the grandfather of technical analysis. A) Harry Markowitz B) William Sharpe C) Charles Dow D) Benjamin Graham E) none of the above Answer: C Difficulty: Easy Rationale: Charles Dow, the originator of the Dow Theory, was the grandfather of technical analysis. Benjamin Graham might be considered the grandfather of fundamental analysis. Harry Markowitz and William Sharpe might be considered the grandfathers of modern portfolio theory. 19. The goal of the Dow theory is to A) identify head and shoulder patterns. B) identify breakaway points. C) identify resistance levels. D) identify support levels. E) identify long-term trends. Answer: E Difficulty: Easy Rationale: The Dow theory uses the Dow Jones Industrial Average as an indicator of long-term trends in market prices. 20. A long-term movement of prices, lasting from several months to years is called _________. A) a minor trend B) a primary trend C) an intermediate trend D) trend analysis E) B and D Answer: B Difficulty: Easy Rationale: Minor trends are merely day-to-day price movements; intermediate trends are or offsetting movements in one direction after longer-term movements in another direction; trends lasting for the period described above are primary trends.

Chapter 12 Behavioral Finance and Technical Analysis

21. A daily fluctuation of little importance is called ____________ A) a minor trend B) a primary trend C) an intermediate trend D) a market trend E) none of the above Answer: A Difficulty: Easy 22. Price movements that are caused by short-term deviations of prices from the underlying trend line are called A) primary trends. B) secondary trends. C) tertiary trends. D) Dow trends. E) contrary trends. Answer: B Difficulty: Easy Rationale: The secondary trend is caused by these deviations, which are eliminated by corrections that bring the prices back to the trend lines. 23. The Dow theory posits that the three forces that simultaneously affect stock prices are ____________. I) II) III) IV) V) A) B) C) D) E) primary trend intermediate trend momentum trend minor trend contrarian trend

I, II, and III II, III, and IV III, IV and V I, II, and IV I, III, and V

Answer: D Difficulty: Moderate

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24. The Elliot Wave Theory ____________. A) is a recent variation of the Dow Theory B) suggests that stock prices can be described by a set of wave patterns C) is similar to the Kondratieff Wave theory D) A and B E) A, B, and C Answer: E Difficulty: Easy Rationale: Both the Elliot Wave Theory and the Kondratieff Wave Theory are recent variations on the Dow Theory, which suggests that stock prices move in identifiable wave patterns. 25. A trin ratio of less than 1.0 is considered as a _________. A) bearish signal B) bullish signal C) bearish signal by some technical analysts and a bullish signal by other technical analysts D) bullish signal by some fundamentalists E) C and D Answer: B Difficulty: Easy Rationale: A trin ratio of less than 1.0 is considered bullish because the declining stocks have lower average volume than the advancing stocks, indicating net buying pressure. 26. On October 29, 1991 there were 1,031 stocks that advanced on the NYSE and 610 that declined. The volume in advancing issues was 112,866,000 and the volume in declining issues was 58,188,000. The trin ratio for that day was ________ and technical analysts were likely to be ________. A) 0.87, bullish B) 0.87, bearish C) 1.15, bullish D) 1.15, bearish E) none of the above Answer: A Difficulty: Moderate Rationale: (1,031/610) / (112,866,000/58,388,000) = 0.87. A trin ratio less than 1 is considered bullish because advancing stocks have a higher volume than declining stocks, indicating a buying pressure.

Chapter 12 Behavioral Finance and Technical Analysis

27. In regard to moving averages, it is considered to be a ____________ signal when market price breaks through the moving average from ____________. A) bearish; below B) bullish: below C) bearish; above D) bullish above E) B and C Answer: E Difficulty: Moderate 28. Two popular moving average periods are A) 90-day and 52 week B) 180-day and three year C) 180-day two year D) 200-day and 53 week E) 200-day and two year Answer: D Difficulty: Moderate 29. ____________ is a measure of the extent to which a movement in the market index is reflected in the price movements of all stocks in the market. A) put-call ratio B) trin ratio C) Breadth D) confidence index E) all of the above Answer: C Difficulty: Moderate 30. Then confidence index is computed from ____________ and higher values are considered ____________ signals. A) bond yields; bearish B) odd lot trades; bearish C) odd lot trades; bullish D) put/call ratios; bullish E) bond yields; bullish Answer: E Difficulty: Moderate

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31. The put/call ratio is computed as ____________ and higher values are considered ____________ signals. A) the number of outstanding put options divided by outstanding call options; bullish or bearish B) the number of outstanding put options divided by outstanding call options; bullish C) the number of outstanding put options divided by outstanding call options; bearish D) the number of outstanding call options divided by outstanding put options; bullish E) the number of outstanding call options divided by outstanding put options; bullish Answer: A Difficulty: Moderate 32. The efficient market hypothesis ____________. A) implies that security prices properly reflect information available to investors B) has little empirical validity C) implies that active traders will find it difficult to outperform a buy-and-hold strategy D) B and C E) A and C Answer: E Difficulty: Moderate 33. Tests of market efficiency have focused on ____________. A) the mean-variance efficiency of the selected market proxy B) strategies that would have provided superior risk-adjusted returns C) results of actual investments of professional managers D) B and C E) A and B Answer: D Difficulty: Moderate 34. The anomalies literature ____________. A) provides a conclusive rejection of market efficiency B) provides a conclusive support of market efficiency C) suggests that several strategies would have provided superior returns D) A and C E) none of the above Answer: C Difficulty: Moderate

Chapter 12 Behavioral Finance and Technical Analysis

35. Behavioral finance argues that ____________. A) even if security prices are wrong it may be difficult to exploit them B) the failure to uncover successful trading rules or traders cannot be taken as proof of market efficiency C) investors are rational D) A and B E) all of the above Answer: D Difficulty: Moderate 36. Markets would be inefficient if irrational investors __________ and actions if arbitragers were __________. A) existed; unlimited B) did not exist; unlimited C) existed; limited D) did not exist; limited E) none of the above Answer: C Difficulty: Moderate 37. If prices are correct __________ and if prices are not correct __________. A) there are no easy profit opportunities; there are no easy profit opportunities B) there are no easy profit opportunities; there are easy profit opportunities C) there are easy profit opportunities; there are easy profit opportunities D) there are easy profit opportunities; there are no easy profit opportunities E) none of the above Answer: A Difficulty: Moderate 38. __________ can lead investors to misestimate the true probabilities of possible events or associated rates of return. A) Information processing errors B) Framing errors C) Mental accounting errors D) Regret avoidance E) all of the above Answer: A Difficulty: Moderate

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39. Kahneman and Tversky (1973) report that people __________ and __________. A) people give too little weight to recent experience compared to prior beliefs; tend to make forecasts that are too extreme given the uncertainty of their information B) people give too much weight to recent experience compared to prior beliefs; tend to make forecasts that are too extreme given the uncertainty of their information C) people give too little weight to recent experience compared to prior beliefs; tend to make forecasts that are not extreme enough given the uncertainty of their information D) people give too much weight to recent experience compared to prior beliefs; tend to make forecasts that are not extreme enough given the uncertainty of their information E) none of the above Answer: B Difficulty: Difficult 40. Errors in information processing can lead investors to misestimate __________. A) true probabilities of possible events and associated rates of return B) true probabilities of possible events C) rates of return D) the ability to uncover accounting manipulation E) fraud Answer: A Difficulty: Moderate 41. DeBondt and Thaler (1990) argue that the P/E effect can be explained by __________. A) forecasting errors B) earnings expectations that are too extreme C) earnings expectations that are not extreme enough D) regret aviodance E) A and B Answer: E Difficulty: Moderate 42. Barber and Odean (2001) report that men trade __________ frequently than women and the frequent trading leads to __________ returns. A) less; superior B) less; inferior C) more; superior D) more; inferior E) none of the above Answer: D Difficulty: Moderate

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43. Conservatism implies that investors are too __________ in updating their beliefs in response to new evidence and that they initially __________ react to news. A) quick; overreact B) quick; under react C) slow; overreact D) slow; under react E) none of the above Answer: D Difficulty: Moderate 44. If information processing were perfect, many studies conclude that individuals would tend to make __________ decision using that information due to __________. A) less-than-fully rational; behavioral biases B) fully rational; behavioral biases C) less-than-fully rational; fundamental risk D) fully rational; fundamental risk E) fully rational; utility maximization Answer: A Difficulty: Moderate 45. The assumptions concerning the shape of utility functions of investors differ between conventional theory and prospect theory. Conventional theory assumes that utility functions are __________ whereas prospect theory assumes that utility functions are __________. A) concave and defined in terms of wealth; s-shaped (convex to losses and concave to gains) and defined in terms of loses relative to current wealth B) convex and defined loses relative to current wealth; s-shaped (convex to losses and concave to gains) and defined in terms of loses relative to current wealth C) s-shaped (convex to losses and concave to gains) and defined in terms of loses relative to current wealth; concave and defined in terms of wealth D) s-shaped (convex to losses and concave to gains) and defined in terms of wealth; concave and defined in terms of loses relative to current wealth E) convex and defined in terms of wealth; concave and defined in terms of gains relative to current wealth Answer: A Difficulty: Difficult

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46. The law-of-one-price posits that ability to arbitrage would force prices of identical goods to trade at equal prices. However, empirical evidence suggests that __________ are often mispriced. A) Siamese Twin Companies B) equity carve outs C) closed-end funds D) A and C E) all of the above Answer: E Difficulty: Difficult Essay Questions 47. Compare and contrast the efficient market hypothesis with the school of thought termed behavioral finance. Difficulty: Difficult Answer: The efficient market hypothesis posits that investors are fully informed, rational, utility maximizers. Thus, security prices will fully reflect all information available to the investors. If any security becomes mispriced, the collective buying and selling actions of investors will quickly cause prices to change. Given an efficient market, it would be difficult to find a trading rule that would consistently outperform the market. Moreover, failure to uncover profitable trading strategies may be taken as proof of market efficiency. Behavioral finance argues that conventional theory ignores how real people make decisions and that people make a difference. Behavioral finance says that investors possess two irrationalities. First, investors do not always process information correctly and secondly they often make systematically suboptimal decisions. Given less than perfectly rational investors, prices may be wrong and it still may be hard to exploit them. Thus, failure to uncover profitable trading strategies may not be taken as proof of market efficiency.

Chapter 12 Behavioral Finance and Technical Analysis

48. Behavioral finance posits that investors possess information processing errors. Discuss the importance of information processing errors then list and explain the four information processing errors discussed in the text. Difficulty: Difficult Answer: Information processing errors are important because they can lead investors to misestimate the true probabilities of possible events or associated rates of return. The four information processing errors are forecasting errors, overconfidence, conservatism, and sample size neglect. Forecasting errors arise when people give too much weight to recent experience. This leads to forecasts that are too extreme. Overconfidence refers to traders believing that they are better than average. This belief that they are superior leads to frequent trading (and according to empirical evidence, lower returns). Conservatism refers investors being slow in responding to new information rather than acting immediately. Sample size neglect refers to investors ignoring the size of a sample and making inferences based on a small sample. 49. Behavioral finance posits that investors possess behavioral biases. Discuss the importance of behavioral biases then list and explain the four behavioral biases discussed in the text. Difficulty: Difficult Answer: Behavioral biases are important because even if information processing was perfect, individuals may tend to make less-than-fully rational decisions using that information. The four behavioral biases are framing, mental accounting, regret avoidance, and prospect theory (or loss aversion). Framing refers to the tendency of investors to change preferences due to the way an investment is framed (i.e., in terms of risk or in terms of return). Mental accounting is a specific form of framing where an investor takes a lot of risk with one investment account but little risk with another account. Regret avoidance refers to the tendency of investors to blame themselves more for an unconventional investment that was unsuccessful than a conventional investment that was unsuccessful. Prospect theory (loss avoidance) suggests that the investor's utility curve is not concave and defined in terms of wealth. Instead, the investor's utility function would be defined in terms of losses relative to current wealth. Thus, the utility curve is convex to losses and concave to gains giving rise to an s-shaped utility curve.

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50. Discuss what technical analysis is, what technical analysts do, and the relationship between technical analysis, fundamental analysis, and behavioral finance. Difficulty: Difficult Answer: Technical analysis attempts to exploit recurring and predictable patterns in stock prices to generate superior portfolio performance. To determine recurring patterns, technical analysts examine historical returns by means of charts and or time-series analysis (such as moving averages). Technical analysts do not deny fundamental analysis but believe that prices adjust slowly to new information. Therefore, the key is to exploit the slow adjustment to the correct new price when information is released. Technical analysts also use volume and other data to assess market sentiment in an attempt to ascertain the future direction of the market. Behaviorists believe that behavioral biases may be related to both price and volume data. Thus, technical analysis can be related to behavioral finance.