Investment Theory - Note 9

What is behavioral finance?

The study of how psychological factors affect financial decisions and markets.

How does behavioral finance challenge traditional finance?

It questions the assumption that investors always make rational decisions.

What is an irrational investor?

An investor who processes information poorly or makes systematically suboptimal decisions.

Do irrational investors necessarily make markets inefficient?

No. Arbitrageurs may correct mispricing, but face practical limits.

What are forecasting errors?

Errors in predicting outcomes or interpreting future information.

What is overconfidence?

Overestimating one's knowledge, abilities, or forecast precision.

What is conservatism bias?

Updating beliefs too slowly when new evidence arrives.

What is representativeness bias?

Inferring broad patterns from small or unrepresentative samples.

An investor ignores new bad news and keeps an old forecast. Which bias?

Conservatism bias.

An investor assumes three winning trades prove exceptional skill. Which bias?

Representativeness bias.

What is framing?

A decision being influenced by how alternatives are presented.

What is mental accounting?

Treating money or investment decisions as separate mental accounts.

What is regret avoidance?

Choosing conventional actions to reduce potential regret or self-blame.

What does prospect theory evaluate?

Gains and losses relative to a reference point, not only total wealth.

What is the reference point in prospect theory?

The starting position against which gains and losses are judged.

What does loss aversion mean?

A loss of a given size hurts more than an equal gain pleases.

What does the prospect-theory value-function graph emphasize?

Value depends on gains and losses, with a steeper loss side.

An investor dislikes a $100 loss more than enjoying a $100 gain. What bias?

Loss aversion, consistent with prospect theory.

Someone treats a tax refund differently from salary income. Which bias?

Mental accounting.

An investor follows the crowd to avoid blame for an unusual mistake. Which bias?

Regret avoidance.

What are limits to arbitrage?

Risks and costs preventing traders from fully correcting mispricing.

What is fundamental risk in arbitrage?

A mispriced security may become even more mispriced before correcting.

Why can arbitrageurs lose money despite identifying mispricing?

Prices may move further away from fundamental value.

Why does an investor's time horizon matter in arbitrage?

Prices may not converge to fair value before the investor must exit.

What are implementation costs?

Trading costs and constraints, including short-selling costs or restrictions.

What is model risk?

The risk that a valuation model is wrong about an apparent opportunity.

What is the law of one price?

Effectively identical assets should have identical prices.

What are Siamese twin companies in this chapter?

Related listed companies used to illustrate apparent pricing discrepancies.

What example illustrates Siamese twin pricing in Note 09?

Royal Dutch and Shell.

What is an equity carve-out?

A parent company sells an ownership interest in a subsidiary.

Which equity carve-out example is mentioned in Note 09?

3Com.

What closed-end fund pricing anomaly appears in the chapter?

Shares can trade at substantial discounts or premiums to NAV.

Why might apparent mispricing persist?

Arbitrage may be risky, costly, or difficult to implement.

What is technical analysis?

Studying past prices and market indicators to identify possible trends.

What effect does technical analysis often seek to identify?

Momentum in stock prices.

What is Dow theory?

A method for identifying primary, intermediate, and minor price trends.

What is a primary trend?

The long-term direction of prices over months or years.

What is an intermediate trend?

A shorter-term deviation or correction within the primary trend.

What is a minor trend?

A daily price fluctuation of relatively little importance.

Can a market have an upward primary trend and temporary declines?

Yes. Intermediate corrections may occur within an upward primary trend.

Why is Dow theory difficult to use in real time?

Trends are easier to identify afterward than while they develop.

What is a moving average?

The average price or index level over a specified recent period.

What does a moving average do to price data?

It smooths short-term fluctuations.

What is a 52-week moving average?

The average index level across the most recent 52 weeks.

What is market breadth?

How widely a market movement is shared by individual stocks.

How is market breadth commonly measured?

By comparing the numbers of advancing and declining stocks.

What is relative strength?

A stock's or industry's recent performance relative to a market index.

What is the TRIN statistic in Note 09?

Average volume in declining issues divided by that in advancing issues.

What is the confidence index?

Top-rated corporate bond yield divided by intermediate-grade bond yield.

What is short interest?

The total number of shares currently sold short.

What is the put/call ratio in Note 09?

The ratio of outstanding put options to outstanding call options.

What is data mining in technical analysis?

Finding apparent trading patterns through repeated searches of past data.

Does a trading rule that worked historically guarantee future profits?

No. Past patterns may be accidental and fail out of sample.

What does comparing simulated and actual price charts illustrate?

Random price movements can appear to contain meaningful patterns.