2.4.BKM Ch 12

  1. Behavioral Critique
    • Conventional financial theory ignores how people really make decisions under uncertainty
    • People commonly make errors inferring prob dist
    • People often make suboptimal decisions
  2. Examples of Information Processing Errors
    • Forecasting errors: too much weight to recent evidence
    • Overconfidence in estimation of returns
    • Conservatism: slow to update prior beliefs
    • Sample size neglect and representativeness: people tend to infer patterns from limited information
  3. Examples of Behavioral Biases
    • Framing: seek gain but avoid losses
    • Mental accounting: using "your" money vs using gains
    • Regret avoidance: shy away from out of favor stocks
    • Prospect theory: instead of defining utility based on wealth, we use change in wealth
  4. 3 factors that reduce arbitrage opportunities
    • Fundamental risk: even true assumption about price violation can require long-term investment w/ potential losses before gains
    • Implementation cost: for example transaction costs
    • Model risk: always a possibility that your model is wrong
  5. 3 examples of Law of One Price violation
    • Siamese twin companies: 2 merging companies agreed on a 60/40 profit split, but stock prices were not exactly adjusted
    • Equity carve outs: volume of stocks and short selling trend can make it barely impossible to actually short sale
    • Closed-end funds: mkt value of closed-end mutual funds shares reflect a substantial discount from the net asset value
  6. 3 methods to identify trend
    • Dow theory: stock prices are driven by (a) primary trends (long term movement), (b) secondary trends (intermediate term), and (c) minor trends (daily fluctuations)
    • Moving average: smooth out short-term fluctuations to make it easier to spot chg in trends
    • Breadth: compare nb of winners and losers
  7. 3 tools to capture change in investor sentiment
    • Trin statistics: ratio of avg declining to rising stocks
    • Confidence index: ratio of high grade corporate bond yield to intermediate grade corporate bond yield
    • Put/Call ratio: hovers around 0.65
Card Set
2.4.BKM Ch 12