Topic 5 - Market Efficiency and Behavioural Finance

Commerce 2240 with Limkriangkrai at Monash University

About this deck

By: Iori Nishida
Created: 2011-09-03
Size: 23 flashcards
Views: 51

About StudyBlue

STUDYBLUE makes things that make you better at school. Things like online flashcards with photos and audio. Things like personalized quizzes and friendly reminders about when (and what) to study next. Think of it as a digital backpack™: access to all of your study materials online and on your phone. STUDYBLUE exists to make studying efficient and effective for every student, for free. Join us.

“Simply amazing. The flash cards are smooth, there are many different types of studying tools, and there is a great search engine. I praise you on the awesomeness.”
Dennis

Sign up (free) to study this.

Explain concept of EMH

EMH states that a market is efficient if:

security prices immediately and fully reflect all available relevant information
the reaction to new information is instantaneous and unbiased

Define the Three forms of EMH

Weak: Stock prices already reflect all past information such as past prices and trading volume. Empirical evidence supports the weak-form.

Semi-Strong: Stock prices already reflect all publicly available information.

Strong: Stock prices already reflects all information, whether publicly available or private held, that is relevant to the firm.

What is the rationale for expecting an efficient capital market. (E.C.M)

A large number of independent, profit-maximising investors engaged in the analysis and valuation of securities.
New information comes to the market in a random fashion; the investors adjust security prices rapidly to reflect this new information. Thus, independent and random price changes.
All information to reflect the "true" current value of stock.

Describe the two sets of tests used to examine the weak-form EMH

Statistical Tests of Independence (S.T.I)
Tests of Trading Rules (T.T.R)

Explain Statistical tests of independence

S.T.I can be divided further into 2 groups: The auto-correlation tests and runs test.

The autocorrelation examines the correlation of price changes on a particular day with a series of consecutive previous days. (i.e. Trading on Thursday than Monday)

The runs tests attempts to determine the pattern of the changes in a series.

What does the EMH imply for the use of Technical Analysis.

The concept of E.C.M contends that there is a rapid dissemination process and prices reflect all information. However, for T.A, the dissemination process is slow - Adjustments of prices is not immediate but forms a pattern.

Thus, no value to T.A because technicians act after the news is made public which would be ineffective in an efficient market.

What does the EMH imply for the use of Fundamental Analysis.

Fundamental Analysis is the analysis of the intrinsic value - the underlying value of an asset before choosing it as an investment.

If the determination of the intrinsic value is based solely on historical data, it will be of little value in providing above average returns.

Describe the role of a portfolio manager in a perfectly efficient market

Constructing and implementing an integrated set of steps to create and maintain appropriate combinations of investment assets.

Briefly describe the 5 steps of portfolio management.

Determine appropriate objectives and identify and evaluate constraints.
Monitoring and evaluating Capital Market Expectations.
Set investment policies and implement through optimal asset allocation. Elimination of specific risk becomes extremely important in E.M.
Monitoring (Investor's circumstances, Market conditions, Relative asset category %)
Portfolio Adjustments

List all Portfolio Constraints

Risk Tolerance
Require Rate of Return
Time horizon
Taxes Considerations
Form of Income Needs
Liquidity
Legal and Regulatory Constraints

Goals of an Index fund?

Index Fund is a type of mutual fund with a portfolio constructed to match or track the components of a market index.

The index funds are intended to match the market and minimise costs. Thus they are consistent with the EMH.

Forces that are helping to maintain perceptions of market inefficiency

Market Structure Forces (M.S.F)
Behavioural Forces (B.F)

Explain the Market Structure Forces.

Uncertainty means that extreme observations are found in distributions (Coin Toss)
Difficult to distinguish skill from luck
Rarely many observations to test under the same conditions (i.e. similar skills)
Vested interests in maintaining inefficiency

Explain the Behavioural Forces.

Aversion to loss realisation (Winners disclose, losers hide)

Individuals appear to have an aversion to loss realisation
Paper losses are somehow better than real losses

Illusion of knowledge (Overconfidence: hubris)
Attribution Theory (Skill versus luck)

What is meant by Prospect Theory

Prospect Theory uses the product of a subjective value function and a non-linear probability weighting in modelling individual choice (Kahneman & Tversky 1979).

Σπ(p_i)v(x_i)

Investors are risk seekers when they face losses and risk averse when they face profits. Therefore, investors prefer to hold the asset if there is a chance of recovering the loss in the future.

What is behavioural finance and what are the two assumptions made in finance?

Behavioural finance combines results from psychological studies of decision-making with the more conventional decision-making models of standard finance theory.

Finance Assumptions:

People make Rational Decisions
People are unbiased in their predictions about the future

Why has behavioural finance become an important field of study in finance?

An understanding of the psychological basis for these errors may help them avoid these errors and improve investment results.

Also, understanding the psychological basis for the basis of success and contrarian strategy can help investors fine-tune these strategies to better exploit the opportunities that collective mental mistakes create.

What is the disposition effect?

The disposition effect occurs when investors tend to hold on to loss-making shares too long and sell profitable investments too soon.

Explain the concepts of representativeness

Representativeness is a term used to describe a shortcut that the brain uses to reduce the complexity of thought.

The effect can be seen when certain shared qualities are used to classify stocks. A tendency to label stocks as either bad-to-own or good-to-own will lead to errors when other relevant characteristics are not considered.

How does myopic risk aversion influence investor behaviour?

The term myopic risk aversion refers to the tendency of decision makers to be short-sighted in their choices about activities that involve potential losses (Gambling).

Investors that hold less than the optimal amount of equities due to fear of potential loss is termed as "Short-sightedness myopic risk aversion"

Give me an example of Mental Accounting:

"Income needs should be met entirely through interest income and cash dividends. All equity securities held should pay cash dividends"

Investors segregate funds into mental accounts, maintain a set of separate mental accounts and do not combine outcomes.

Give some examples of Over Confidence:

"I have not kept records on the performance of similar past investments, but i have had some "big winners". The desire to select investments that are inconsistent with his overall strategy indicates overconfidence. Overconfident individuals often exhibit risk-seeking behaviour.

Causes include:

illusion of control / Self-enhancement tendencies
Insensitivity to predictive accuracy / misconceptions of chance processes

Give some examples of Reference Dependence:

"If an investments falls below the purchase price, the security should be retained until it returns to its original cost." Investor's desire to retain poor performing investments and to take quick profits on successful investments suggest reference dependence - decisions are critically dependent on decision maker's reference point.

Preferences are susceptible to manipulation simple by changing the reference point.

About this deck

By: Iori Nishida
Created: 2011-09-03
Size: 23 flashcards
Views: 51

About StudyBlue

“Simply amazing. The flash cards are smooth, there are many different types of studying tools, and there is a great search engine. I praise you on the awesomeness.”
Dennis