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

Even if weak form market efficiency is true, it does not mean that studying charts of past prices and searching for repeating pattern is useless.

Answer 2

False

Question 3

The strong form of the efficient market hypothesis contends that

A) a select few institutional investors can earn abnormal profits.
B) no one can ever outperform the market.
C) no one can consistently earn a profit.
D) no one can consistently earn abnormal profits.

Answer 3

D

Question 4

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

Question 5

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 6

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

Question 7

Which one of the following activities is likely to be useful if the market is only weak form efficient?

A) attempting to find the best times to buy and sell
B) attempting to find repeating pattern in stock price behavior
C) attempting to determine if stock prices have upward or downward momentum
D) studying financial, economic and industry information about a company

Question 8

In an efficient market, the only way to earn higher returns is to invest in riskier securities.

Question 9

Which of the following would invalidate the weak form of the efficient market hypothesis.

A) Patterns in price behavior that consistently predict future price movements.
B) Market analysis proves useful in discovering investment opportunities.
C) Stocks of smaller firms consistently outperform larger firms.
D) Shortly before she is arrested, a pharmaceutical company researcher makes a large profit on her company's stock by buying just before a new drug is approved by the Food and Drug Administration.

Question 10

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 11

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 12

In a semi-strong efficient market, traders with non-public information would have no advantage over those who had only public information.

Question 13

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

Question 14

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 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

The process of buying an underpriced security and selling an equivalent overpriced security until the prices converge is known as arbitrage.

Question 17

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

Question 18

According to the semi-strong form of the efficient market hypothesis, which of the following might lead to extraordinary profits?

A) studying charts of a stock's past price behavior
B) thoroughly analyzing the state of the economy, the industry and the company's fundamentals
C) possessing private information not available to other investors
D) carefully timing trades to buy when the price is low and sell when the price is high

Question 19

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

Question 20

Even if the semi-strong version of the efficient market hypothesis is true, it might be possible to earn extraordinary returns from private information not available to other investors.

Question 21

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 22

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 23

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

Question 24

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 25

If half of all actively managed mutual funds outperform the market indexes in any given year, the efficient market hypothesis cannot be valid.

Question 26

The apparent randomness of stock price movements is powerful evidence against market efficiency.

Question 27

Some behavioral characteristics cause investors to realize lower investment returns.

Question 28

Loss aversion is the behavior of excessively conservative investors.

Question 29

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

Question 30

Self-attribution bias causes investors to take responsibility for their unsuccessful investment choices.

Question 31

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) Stock prices respond to new information.
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 32

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

Question 33

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 insider information.
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 34

Self-attribution is the trait of believing one's successful choices are the result of skill and hard work whereas failures are due to bad luck or the fault of others.

Question 35

Research in psychology indicates that most people have very little faith in their ability to perform complex tasks.

Question 36

Which of the following is true about index funds?

A) They consistently outperform 75% of actively managed funds.
B) They make no effort to select the best performing stocks.
C) They consistently underperform 75% of actively managed funds.
D) They outperform the market by selling the weakest companies in the index and weighting the strongest companies more heavily.

Question 37

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

Question 38

The process that quickly eliminates price discrepancies in efficient markets is known as

A) arbitration.
B) market correction.
C) arbitrage.
D) random fluctuation.

Question 39

Believers in efficient markets tend to explain away market anomalies as
I) random occurrences that create an illusion of causality.
II) errors resulting from inaccurate measures of risk.
III) the result of illegal price manipulation by corporate insiders.
IV) the effect of normal human emotions such as fear and greed.

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

Question 40

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 41

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 42

In the last year, Bradley purchased 3 stocks on recommendations from his broker, Emily. All of the stocks have increased in value, so he decides to act on all of Emily's recommendations in the future. Over the same period, the S&P 500 was up 15%. Bradley exhibits the tendency known as

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

Question 43

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

Question 44

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 45

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

Question 46

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 47

Heather has the equivalent of one year's income in an insured savings account. Her 401-K fund offers a choice of a government bond fund, an S&P 500 Index fund, and a balanced fund that holds roughly equal amounts of stocks and bonds. If she decided to allocate 1/3 of her retirement investments to each fund, she may be a victim of

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

Question 48

The so-called Super Bowl effect is a serious challenge to the efficient market hypothesis.

Question 49

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 50

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 51

Investor overconfidence leads to

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

Question 52

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

Question 53

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 54

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 55

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 56

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
III) holding on to a stock that has dropped in value because you would be willing to buy it at its current price
IV) overestimating one's ability to pick successful investments

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

Question 57

Jason has decided to sell his stock in an energy company because gas and oil prices as well the price of his stock have declined in 5 of the last 6 months. Jason has most likely fallen into the trap known as

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

Question 58

Jordan purchased 400 shares of GE at $16 per share. The price has dropped to $11 and he is disappointed in his purchase, but he is determined not to sell until the price again reaches $16. His decision is based on

A) overconfidence.
B) belief perserverance.
C) loss aversion.
D) representativeness.

Question 59

Stocks of small companies have a historical tendency to outperform large cap stocks in the month of January.

Question 60

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 outperform large cap stocks
D) equities in general tend to increase

Question 61

Investors should never combine fundamental analysis and technical analysis.

Question 62

One market anomaly that offers some evidence in support of charting or other forms of technical analysis is

A) the small firm effect.
B) momentum.
C) the January effect.
D) the value effect.

Question 63

Barb and Ken purchased a house for $300,000 in 2005. When they needed to sell because of a job transfer in 2009, the house was appraised for $250,000 but they put it on the market for $300,000 anyway. The house is still on the market. Behavioral tendencies at work here may include

A) representativeness and narrow framing.
B) overconfidence and representativeness.
C) familiarity bias and self attribution bias.
D) loss aversion and anchoring.

Question 64

When the number of issues with rising prices exceeds the number with declining prices for a period of time, the market is considered strong.

Question 65

Resources for technical analysis are readily available on the Internet.

Question 66

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

Question 67

From a behavioral perspective, the anomaly known as post-earnings announcement drift or momentum is best explained by

A) self attribution bias.
B) loss aversion.
C) representativeness.
D) familiarity bias.

Question 68

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

Question 69

The stock price of PHRM declined by 30% when the FDA did not approve a promising new therapy the company was developing. Patrick holds on to the stock and constantly searches the internet looking for favorable stories about the company while ignoring a cascade of negative reports. This is an example of

A) anchoring.
B) overconfidence.
C) belief perseverance.
D) narrow framing.

Question 70

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

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

Question 71

On-balance volume charts the difference between the number of advancing issues and the number of declining issues.

Question 72

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

Question 73

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

Question 74

The tendency of naive investors to buy high (after prices have risen for several periods) and sell low (after prices have dropped for several periods) can be explained by the behavioral tendency known as

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

Question 75

The confidence index is based on the difference between the yields on 3 month Treasury bills and the 10 Treasury bond.

Question 76

Technical analysis is so called because it relies on sound scientific principles rather than intuition.

Question 77

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

Question 78

On-balance volume is a secondary indicator used to confirm price trends.

Question 79

The new high-new lows measure suggests that buying opportunities occur when new lows outnumber new highs.

Question 80

Efficient market proponents tend to explain market anomalies as

A) inaccurate risk measurements.
B) temporary phenomena.
C) statistical accidents.
D) all of the above