A.07.BKM Ch 12

  1. 2 categories of irrationalities
    • information processing: thus deriving incorrect probability dist
    • behavioral bias: implying inconsistent/suboptimal decisions
  2. Information processing irrationalities
    • forecasting errors: too much weight to recent, too extreme forecast given uncertainty
    • overconfidence
    • conservatism: slow to update belief
    • sample size neglect & representativeness: don't account for sample size
  3. Behavioral biases irrationalities
    • framing: decision impacted by how it's framed
    • mental accounting: segregating decisions
    • regret avoidance: more regret if loss due to unconventional decision
    • prospect theory: utility depends on change in wealth
  4. Behavioral finance - limits to arbitrage
    • fundamental risk: actions not risk free, mispricing could get worse
    • implementation cost: might be asked to return short selled asset, some can't short sell
    • model risk: prices could indeed be valid
  5. Known violations of law of one price
    • siamese twin cpies: split profits 60/40 but stock price didn't follow. Arbitrageurs lost money because deviations grew
    • equity carve-outs: close Palm, pay 1.5 share. Stock relativity was below 1, but no shares available
    • closed-end funds: usually trade for disc/prem but can be explained (expenses)
  6. Behavioral critique
    • too unstructured: allows virtually all anomalies to be explained
    • inconsistent anomalies
    • wrong benchmark selection could cause apparent misprice
  7. Behavioral finance - technical analysis
    • disposition effect: investors hold on to losing investments
    • volume data: overconfident trade more -> relationship btwn trade vol & return
    • mkt fundamentals will be disturbed by irrational factors
  8. Behavioral finance - trends & corrections
    • Dow theory: primary/intermediate/minor trends
    • Moving average: break from below = bullish (decr to incr)
    • Breadth: spread btwn # incr vs decr stocks. If # incr way above decr = strong
  9. Mkt sentiment indicators
    • trin statistic: (vol / # decr) / (vol / # incr). Above 1 = bearish
    • confidence index: yield top 10 corp bds / intermediate. Close to 1 = strong
    • Put/Call ratio: incr in ratio indicates bearish mkt
Card Set
A.07.BKM Ch 12
Behavioral Finance