Deck 9: Market Efficiency and Behavioral Finance

Question 1

Security markets have been described as random walks and efficient markets. What does each of these terms mean and how do they relate to the stock market? What makes a market efficient and what are the consequences of efficiency for fundamental and technical analysis?

Answer 1

Random walk refers to the belief that price changes in the market do not follow any pattern but occur on a purely random basis.
An efficient market means that information is quickly and accurately reflected in security prices. The quick and widespread availability of information, and the fact that people conduct security analysis, makes the market efficient.
In an efficient market, neither fundamental nor technical analysis is of real value. If markets are totally efficient, then it is impossible to consistently outperform the market.

Question 2

Historically higher returns on the stocks of small companies can be completely explained by their higher risk.

Answer 2

False

Question 3

If stock prices move randomly, charting and technical analysis are useful investment tools.

Answer 3

False

Question 4

The efficient market hypothesis rests on which of the following assumptions?
I) Information is widely available to all investors almost simultaneously.
II) Investors react quickly to new information.
III) Investors correctly interpret all available information.
IV) Events which affect the market occur randomly.

A) I and II only
B) I, II and III only
C) I, III and IV only
D) I, II, III and IV

Question 5

The strong form of the efficient market hypothesis contends that

A) a select few institutional investors can earn abnormal profits.
B) abnormal profits are randomly distributed.
C) no one can consistently earn a profit.
D) no one can consistently earn abnormal profits.

Question 6

Investors skilled in exploiting behavioral errors and market anomalies can consistently outperform the market by a wide margin.

Question 7

Which of the following activities would be most useful in an efficient market.

A) buying and holding a diversified portfolio
B) searching for patterns in charts based on stock price movements
C) analyzing financial ratios based on accounting data
D) buying only securities that have performed well in the recent past

Question 8

Which one of the following best describes the term "efficient market"?

A) The commissions on large transactions are smaller than the commissions on small transactions.
B) New information is quickly reflected in security prices.
C) Little time and effort are spent on marketing securities to the public.
D) The cost of receiving, processing, executing, and reporting securities orders is small.

Question 9

For most companies, the stock price follows the same seasonal pattern as revenues and earnings.

Question 10

Followers of the efficient market hypothesis believe that

A) very few investors actually analyze or evaluate stocks before they make a purchase decision.
B) the needed information to assess the market is available only to corporate insiders.
C) investors react quickly and accurately to new information.
D) individual traders can have a significant impact on the price of a security.

Question 11

Advocates of the weak-form efficient market hypothesis claim that past price movements are the best predictors of future price movements.

Question 12

In an efficient market, the only means of achieving high returns is to invest in high-risk securities.

Question 13

If a company's revenues and earnings are highly predictable, it's stock price will also be highly predictable.

Question 14

Based on the semi-strong form of the efficient market theory, an investor reacting immediately to a news flash on the television generally

A) can make an abnormal profit.
B) is guaranteed to make a reasonable profit.
C) is too late to make an exceptional profit.
D) will suffer a loss.

Question 15

An efficient market reflects

A) only historical information.
B) only the information related to events that have already occurred.
C) all publicly known information related to past events and announced future events.
D) all information including predictions about future information.

Question 16

In an efficient market, prices appear to move randomly because

A) investors do not process new information correctly.
B) only new information affects stock prices.
C) insider trading has an unpredictable effect on stock prices.
D) the number of investors who can forecast prices correctly is too small to have any effect.

Question 17

Even if the semi-strong form of the efficient market hypothesis is true, trading on illegal insider information may lead to abnormal profits.

Question 18

The weak form of the efficient market theory contends that

A) past price performance is useless in predicting future price movements.
B) past performance can help determine the general direction of future price movements.
C) any publicly available information is useless in predicting future price movements.
D) price movements are not random but follow a general trend over a period of time.

Question 19

A type of mutual fund with particular appeal to investors who accept the efficient market hypothesis is

A) index fund.
B) asset allocation fund.
C) growth opportunities fund.
D) emerging markets fund.

Question 20

The efficient market hypothesis means that trades can be executed quickly, easily, and inexpensively.

Question 21

Self attribution bias causes investors to attribute their successes to skill and failures to chance.

Question 22

Which of the following is true?

A) Historically, high P/E or growth stocks have outperformed low P/E or value stocks.
B) Historically, low P/E or value stocks have outperformed high P/E or growth stocks.
C) After adjusting for risk, high P/E or growth stocks and low P/E or value stocks have performed about the same over time.
D) the P/E effect is limited to U.S. stocks.

Question 23

Which one of the following statements concerning the random walk hypothesis is correct?

A) Stock price movements are predictable but only over short periods of time.
B) Random price movements support the weak form efficient market hypothesis.
C) Stock prices in general follow repetitive patterns but the actions of individual investors are random in nature.
D) Random price movements indicate that investors can earn abnormal profits on a routine basis.

Question 24

There is evidence to support the contention that company insiders

A) cannot earn abnormal profits because they are not permitted to trade shares in their company's stock without a one-month advance notice to the SEC.
B) can profit in a manner that counters the strong form of the efficient market hypothesis.
C) generally earn a profit equal to that of public investors.
D) have no distinct advantage when trading shares of their company's stock.

Question 25

Investor overconfidence leads to

A) too little trading.
B) an overestimation of risk.
C) overly optimistic predictions.
D) narrow framing.

Question 26

Which one of the following statements is correct?

A) The weekend effect states that security prices tend to rise between Friday afternoon and Monday morning.
B) The market responds immediately to reflect the information contained in quarterly earnings reports.
C) Low P/E stocks tend to outperform high P/E stocks on a risk-adjusted basis.
D) The market fully anticipates the information contained in an earnings announcement prior to the actual announcement.

Question 27

Most investors quickly sell their losers and hold on to their winners.

Question 28

Analysts tend to issue similar recommendations on individual securities.

Question 29

Fund managers tend to have too little confidence in their abilities leading them to be excessively cautious.

Question 30

Four "decision traps " identified by behavioral finance are

A) overconfidence, representativeness, loss aversion, narrow framing
B) lack of confidence, representativeness, overreaction, narrow framing
C) overconfidence, representativeness, loss aversion, comprehensive framing
D) overconfidence, unfamiliarity bias, loss aversion. narrow framing

Question 31

Market anomalies are caused by

A) investors' efforts to avoid or postpone taxes.
B) different levels of risk.
C) statistical quirks.
D) some poorly understood combination of factors.

Question 32

There is strong evidence that investors who trade frequently outperform the market.

Question 33

Followers of the random walk hypothesis believe that

A) security analysis is the best tool to utilize when investing in the stock market.
B) the price movements of stocks are unpredictable, and therefore security analysis will not help to predict future market behavior.
C) that traders can earn higher than normal returns by exploiting market anomalies such as the small-firm effect.
D) support levels and resistance lines, when combined with basic chart formations, yield both buy and sell signals.

Question 34

Most investors are slow to accept evidence that contradicts their strongly held beliefs.

Question 35

Behavioral finance suggests that investors react to new information in an efficient manner such that security prices accurately reflect the new information.

Question 36

Individuals tend to invest in mutual funds that have recently been performing well.

Question 37

The tendency of investors to blame others for their failures and take personal credit for their successes is referred to as

A) loss aversion.
B) representativeness.
C) narrow framing.
D) self-attribution bias.

Question 38

The random walk hypothesis

A) implies that security analysis is unable to predict future market behavior.
B) suggests that random patterns appear but only over long periods of time.
C) has been disproved based on recent computer simulations.
D) accounts for market anomalies such as calendar effects.

Question 39

Some behavioral characteristics cause investors to realize lower investment returns.

Question 40

Behavioral finance would explain many market anomalies to

A) the influence of human emotions and biases on securities markets.
B) random price movements that only appear to have a rational explanation.
C) poorly understood aspects of market efficiency.
D) illegal manipulation of securities prices.

Question 41

Market bubbles such as the technology bubble of the 1990s and the housing bubble of 2004-2007 are best explained by

A) the efficient market hypothesis.
B) behavioral finance and economics.
C) rational expectations theory.
D) anomaly theory.

Question 42

Which of the following characteristics are referred to as representativeness?
I) hesitating to sell stocks at a loss
II) basing conclusions on small samples
III) underestimating the effects of random chance
IV) underestimating the level of risk in an investment

A) I and IV only
B) II and III only
C) I, II and III only
D) I, II, III and IV only

Question 43

The efficient market hypothesis has some trouble explaining the existence of market anomalies.

Question 44

The tendency to hold onto losing stocks in the hope that they will recoup is called

A) loss aversion.
B) representativeness.
C) narrow framing.
D) biased self-attribution.

Question 45

Evidence suggests that the price of a stock continues to move up or down for a period of

A) a decade or more.
B) 3 to 5 years.
C) 1 to 3 years.
D) 6 to 12 months.

Question 46

The tendency of investors to take greater risks after a large loss and fewer risks after a large gain can be attributed to

A) overconfidence.
B) the "house money" effect.
C) loss aversion.
D) representativeness.

Question 47

Stocks of small companies have a historical tendency to do especially well in the month of January.

Question 48

The anomaly known as post-earnings announcement drift or momentum describes the tendency of stock prices to rise or fall for several ________ after unexpectedly good or bad earnings announcements.

A) months
B) weeks
C) days
D) hours

Question 49

One of the calendar effect market anomalies indicates that ________ in value during January.

A) large cap stocks tend to decline
B) equities in general tend to decline
C) small cap stocks tend to increase
D) equities in general tend to increase

Question 50

People tend to

A) ignore information that contradicts their current beliefs.
B) overestimate the effects of random chance.
C) be underconfident in their judgment of investments.
D) look at the entire situation when analyzing an individual security.

Question 51

Evidence suggests that growth stocks tend to outperform value stocks.

Question 52

Investors who obsessively monitor their last few stock purchases while paying little attention to the rest of their portfolio are exhibiting the tendency known as

A) overconfidence.
B) narrow framing.
C) loss aversion.
D) representativeness.

Question 53

What are some of the more important disagreements between the efficient market hypothesis and the findings of behavioral finance.

Question 54

Which of the following accurately reflect appropriate investment guidelines?
I) Always invest in last years best performing mutual fund.
II) Trade frequently to increase your investment returns.
III) Sell losing stocks unless you are willing to buy them at the current price.
IV) Take corrective action when so indicated.

A) I and II only
B) III and IV only
C) I, III and IV only
D) I, II, III and IV

Question 55

Which of the following statements correctly present recommendations based on behavioral finance?
I) Don't hesitate to sell a losing stock.
II) Trade frequently.
III) Chase performance.
IV) Be humble and open-minded.

A) I and II only
B) I and IV only
C) II and III only
D) III and IV only

Question 56

Even after adjusting for risk, ________ firms earn have, over long periods of time, earned higher returns than ________ firms.

A) small, large
B) large, small
C) new, old
D) old, new

Question 57

Investors who buy mutual funds that have had large gains over the last few years are exhibiting a tendency known as

A) overconfidence.
B) narrow framing.
C) loss aversion.
D) representativeness.

Question 58

Which of the following are common but dysfunctional investor behaviors?
I) overinvesting in companies with familiar names
II) dividing their funds equally among available choices, even if several of the choices serve the same purpose
IV) hastily disposing of stocks that have dropped in price in order to take advantage of tax breaks
IV) exaggerating the role of luck and randomness in investment success or failure

A) I and IV only
B) II and III only
C) I, II and III only
D) I, II, III and IV only

Question 59

Recent academic studies in behavioral finance confirm that markets are even more efficient than previously believed.

Question 60

The most important lesson investors can learn from behavioral finance is

A) to understand psychological factors influencing long-term price movement.
B) to have the humility to let professionals manage their investments.
C) how to avoid letting their emotions and biases affect their investment decisions.
D) to have confidence in their instincts and first impressions.

Question 61

Which of the following are included in technical analysis?
I) charting price movements
II) tracking trading volume
III) determining the investor's risk tolerance
IV) monitoring odd-lot trading

A) I and II only
B) II and III only
C) I, II and III.
D) I, II and IV

Question 62

The breadth of the market refers to the spread between the number of stocks advancing and those declining in value.

Question 63

Resources for technical analysis are readily available on the Internet.

Question 64

Which of the following are used as indicators of a strong market in the future?
I) The advance-decline spread is increasing at a time when the advances outnumber the declines.
II) The level of short interest is relatively high.
III) The net difference of odd-lot purchases minus odd-lot sales begins increasing.
IV) The trading volume increases in a declining market.

A) I and II only
B) III and IV only
C) I, II and III only
D) I, II, III and IV

Question 65

The tendency of small firms to have higher returns than large firms , even after adjusting for risk, may be attributable to

A) representativeness.
B) overconfidence.
C) familiarity bias.
D) loss aversion.

Question 66

Technical analysis is used for which of the following purposes?
I) deciding when to enter the market
II) deciding whether to sell a stock
III) deciding which stocks to buy
IV) deciding whether basic economic conditions are favorable for investing

A) I and II only
B) II and III only
C) I, II and III only
D) I, II, III and IV

Question 67

A principal objective of technical analysis is trying to determine when to invest.

Question 68

A relatively high level of short sells is an indicator of a current bull market.

Question 69

Market volume is a function of market demand for and supply of stocks.

Question 70

Investors should never combine fundamental analysis and technical analysis.

Question 71

Technical analysis primarily monitors shifts in the ________ in the market.

A) level of risk
B) supply and demand forces
C) volume of trading
D) rate of return

Question 72

For technical analysts, the forces of supply and demand have an important effect on the prices of securities.

Question 73

An oversold market is generally considered to be overvalued.

Question 74

The odd-lot trading theory advocates that small investors

A) tend to buy high and sell low.
B) react in a manner which generally forecasts the future direction of the market.
C) are the first to react to market changes.
D) tend to be the first to speculate on a bull market.

Question 75

You are most likely better off doing the opposite of what most investment newsletter experts advise doing.

Question 76

Technical analysis is a mechanical approach to investing.

Question 77

A technical analyst might have an interest in which of the following?
I) level of short interest
II) relative price level
III) point-and-figure charts
IV) odd-lot transactions

A) I and III only
B) I, II and IV only
C) I, II and III only
D) I, II, III and IV

Question 78

The odd-lot theory supports buying into the market when the number of odd-lot trades rises.

Question 79

The principal objective of technical analysis is

A) determining the best time to get into or out of the market.
B) maintaining the lowest level of risk possible.
C) avoiding all unpleasant surprises in the market.
D) increasing trading to improve overall profits.

Question 80

The stock market is considered strong when the market volume decreases in a declining market.