FIN 351
SOLUTIONS MANUAL
CHAPTER 10
BEHAVIORAL FINANCE AND TECHNICAL ANALYSIS
Answers to Text Discussion Questions
1. Discuss market bubbles and offer an opinion on why you think investors have trouble spotting bubbles.
10-1. Markets are not always rational and the herd instinct of following the crowds often causes investors and others to ignore the signs that point to a bubble. Bubbles catch professional investors as well as the novice.
2. Describe the three heuristics that investors use as “rules of thumb.”
10-2. 1) Representativeness: People assess the chances of an event by the similarity of the event to a stereotype. 2) Availability: People remember more recent events more intensely than distant events and the more available the event the more likely it will influence our decisions. 3) Anchoring-and-Adjustment: People make an estimate based on an initial value and then adjust this value to reach a conclusion. Werner DeBondt refers to this as the “first impression syndrome” where we make an initial judgment about someone and over time we may adjust our opinion.
3. If you “buy straw hats in winter” or buy “when there is blood in the street,” what kind of investor are you?
10-3. You are a contrarian because you buy things when they are out of favor hoping that you got a bargain.
4. How does prospect theory differ from standard economic utility theory?
10-4. If people were rational utility theory would work fine and they would choose the highest probable outcome from a list of outcomes that have the same risk. However when people are give a choice between a guaranteed outcome and the probability of a higher outcome, they choose the guaranteed outcome. This behavior is called the certainty effect. 5. What does the overreaction hypothesis state, and what are its implications for investors? 10-5. Academic research shows that investors systematically overreact to unexpected news events and this causes inefficiencies in the stock
CHAPTER 10
BEHAVIORAL FINANCE AND TECHNICAL ANALYSIS
Answers to Text Discussion Questions
1. Discuss market bubbles and offer an opinion on why you think investors have trouble spotting bubbles.
10-1. Markets are not always rational and the herd instinct of following the crowds often causes investors and others to ignore the signs that point to a bubble. Bubbles catch professional investors as well as the novice.
2. Describe the three heuristics that investors use as “rules of thumb.”
10-2. 1) Representativeness: People assess the chances of an event by the similarity of the event to a stereotype. 2) Availability: People remember more recent events more intensely than distant events and the more available the event the more likely it will influence our decisions. 3) Anchoring-and-Adjustment: People make an estimate based on an initial value and then adjust this value to reach a conclusion. Werner DeBondt refers to this as the “first impression syndrome” where we make an initial judgment about someone and over time we may adjust our opinion.
3. If you “buy straw hats in winter” or buy “when there is blood in the street,” what kind of investor are you?
10-3. You are a contrarian because you buy things when they are out of favor hoping that you got a bargain.
4. How does prospect theory differ from standard economic utility theory?
10-4. If people were rational utility theory would work fine and they would choose the highest probable outcome from a list of outcomes that have the same risk. However when people are give a choice between a guaranteed outcome and the probability of a higher outcome, they choose the guaranteed outcome. This behavior is called the certainty effect. 5. What does the overreaction hypothesis state, and what are its implications for investors? 10-5. Academic research shows that investors systematically overreact to unexpected news events and this causes inefficiencies in the stock