Chap012 PDF

Chapter 12 Behavioral Finance and Technical Analysis
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
distribution of returns, they always make consistent and optimal decisions
C) ability to always process information correctly and therefore they infer correct
distribution of returns, they often make inconsistent or suboptimal decisions
D) inability to always process information correctly and therefore they infer incorrect
distribution of returns, they often make inconsistent or suboptimal decisions
Answer: D Difficulty: Moderate
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4. Information processing errors consist of
I) forecasting errors
II) overconfidence
III) conservatism
IV) framing
A) I and II
B) I and III
C) III and IV
D) IV only
E) 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
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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
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
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
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
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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

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
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
263
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
16. Arbitrageurs may be unable to exploit behavioral biases due to ____________.
I) fundamental risk
II) implementation costs
III) model risk
IV) conservatism
V) regret avoidance
A) I and II only
B) I, II, and III
C) I, II, III, and V
D) II, III, and IV
E) IV and V
17. ____________ are good examples of the limits to arbitrage because they show that the
law of one price is violated.
I) Siamese Twin Companies

II) Unit trusts
III) Closed end funds
IV) Open end funds
V) Equity carve outs
A) I and II
B) I, II, and III
C) I, III, and V
D) IV and V
E) V
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18. __________ was the grandfather of technical analysis.

A) Harry Markowitz
B) William Sharpe
C) Charles Dow
D) Benjamin Graham
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

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.
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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
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.

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) primary trend
II) intermediate trend
III) momentum trend
IV) minor trend
V) contrarian trend
A) I, II, and III

B) II, III, and IV
C) III, IV and V
D) I, II, and IV
E) I, III, and V
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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

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

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.
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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
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
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
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
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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
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
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
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
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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
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
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
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
270
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
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
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
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
271
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
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
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
272
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.
273
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.
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.
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.
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.
51. Studies of Siamese twin companies find __________ which __________ the EMH.
A. correct relative pricing; supports
B. correct relative pricing; does not support
C. incorrect relative pricing; supports
D. incorrect relative pricing; does not support
E. none of the above
Studies of Siamese twin companies find incorrect relative pricing which does not support the
EMH.
52. Studies of equity carve-outs find __________ which __________ the EMH.
A. strong support for the Law of One Price; supports
B. strong support for the Law of One Price; violates
C. evidence against the Law of One Price; violates
D. evidence against the Law of One Price; supports
E. none of the above
Studies of equity carve-outs find evidence against the Law of One Price which violates the
EMH.
53. Studies of closed-end funds find __________ which __________ the EMH.
A. prices at a premium to NAV; is consistent with
B. prices at a premium to NAV; is inconsistent with
C. prices at a discount to NAV; is consistent with
D. prices at a discount to NAV; is inconsistent with
E. B and D
Studies of closed-end funds find prices at premiums and discounts to NAV which is
inconsistent with the EMH.
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Chapter 12 Behavioral Finance and Technical Analysis

Multiple Choice Questions

1. Conventional theories presume that investors ____________ and behavioral finance

Answer: B Difficulty: Easy

2. The premise of behavioral finance is that

Answer: A Difficulty: Easy

Answer: D Difficulty: Moderate

4. Information processing errors consist of

Answer: E Difficulty: Moderate

5. Forecasting errors are potentially important because

Answer: B Difficulty: Moderate

Answer: A Difficulty: Moderate

Answer: E Difficulty: Moderate

Answer: C Difficulty: Moderate

9. ____________ may be responsible for the prevalence of active versus passive

Answer: B Difficulty: Moderate

Answer: A Difficulty: Moderate

Answer: D Difficulty: Moderate

Answer: A Difficulty: Moderate

Answer: A Difficulty: Moderate

Answer: A Difficulty: Moderate

15. An example of ________ is that it is not as painful to have purchased a blue-chip

Answer: B Difficulty: Moderate

16. Arbitrageurs may be unable to exploit behavioral biases due to ____________.

Answer: B Difficulty: Moderate

I) Siamese Twin Companies

Answer: C Difficulty: Moderate

18. __________ was the grandfather of technical analysis.

Answer: C Difficulty: Easy

19. The goal of the Dow theory is to

Answer: E Difficulty: Easy

Answer: B Difficulty: Easy

21. A daily fluctuation of little importance is called ____________

Answer: A Difficulty: Easy

Answer: B Difficulty: Easy

A) I, II, and III

Answer: D Difficulty: Moderate

24. The Elliot Wave Theory ____________.

Answer: E Difficulty: Easy

25. A trin ratio of less than 1.0 is considered as a _________.

Answer: B Difficulty: Easy

Answer: A Difficulty: Moderate

27. In regard to moving averages, it is considered to be a ____________ signal when

Answer: E Difficulty: Moderate

28. Two popular moving average periods are

Answer: D Difficulty: Moderate

Answer: C Difficulty: Moderate

Answer: E Difficulty: Moderate

Answer: A Difficulty: Moderate

32. The efficient market hypothesis ____________.

Answer: E Difficulty: Moderate

33. Tests of market efficiency have focused on ____________.

Answer: D Difficulty: Moderate

34. The anomalies literature ____________.

Answer: C Difficulty: Moderate

35. Behavioral finance argues that ____________.

Answer: D Difficulty: Moderate

36. Markets would be inefficient if irrational investors __________ and actions if

Answer: C Difficulty: Moderate

Answer: A Difficulty: Moderate

Answer: A Difficulty: Moderate

Answer: B Difficulty: Difficult