Chapter 10 - Behavioral Finance and Technical Analysis

SOLUTIONS MANUAL
CHAPTER 10
BEHAVIORAL FINANCE AND TECHNICAL ANALYSIS
Answers to Text Discussion Questions
1. Discuss market bubbles and offer an opinion on why you think investors have
trouble spotting bubbles.
10-1. Markets are not always rational and the herd instinct of following the crowds often
causes investors and others to ignore the signs that point to a bubble. Bubbles catch
professional investors as well as the novice.
2. Describe the three heuristics that investors use as rules of thumb.
10-2. 1) Representativeness: People assess the chances of an event by the similarity of
the event to a stereotype.
2) Availability: People remember more recent events more intensely than distant
events and the more available the event the more likely it will influence our decisions.
3) Anchoring-and-Adjustment: People make an estimate based on an initial value
and then adjust this value to reach a conclusion. Werner DeBondt refers to this as the
first impression syndrome where we make an initial judgment about someone and over
time we may adjust our opinion.
3. If you buy straw hats in winter or buy when there is blood in the street,
what kind of investor are you?
10-3. You are a contrarian because you buy things when they are out of favor hoping that
you got a bargain.
4. How does prospect theory differ from standard economic utility theory?
10-4. If people were rational utility theory would work fine and they would choose the
highest probable outcome from a list of outcomes that have the same risk. However when
people are give a choice between a guaranteed outcome and the probability of a higher
outcome, they choose the guaranteed outcome. This behavior is called the certainty
effect.

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Chapter 10 - Behavioral Finance and Technical Analysis

5. What does the overreaction hypothesis state, and what are its implications for
investors?
10-5. Academic research shows that investors systematically overreact to unexpected
news events and this causes inefficiencies in the stock market. DeBondt and Thaler find
that investors overact to both good news and bad news and that past winners become
losers and past losers become winners. You might refer back to page 254 and the real
world of investing box that reads: SPECIAL SITUATION: IS BAD NEWS SOMETIMES GOOD
NEWS FOR INVESTORS?

6. Mental accounting and framing are two behavioral traits investors exhibit. How
do these traits influence decision making?
10-6. Framing refers to the investors frame of reference, which usually has to do with the
purchase price of the stock they own. They tend to not want to sell their losers.
Additionally with mental accounting investors have a tendency to divide their portfolio
into risk buckets and dont focus on their overall wealth.
7. How can momentum investing lead to the winner/loser proposition?
10-7. Momentum investors follow the popular winning stocks that outperform the market
index for some period of time. When the momentum stops, this can lead to the
winner/loser proposition where the extrapolation of past trends ends, which leads to overvaluation and under-valuation.
8. What does behavioral research indicate about the difference between men and
women investors, on average?
10-8. Terry Odean and Brad Barber published research that shows that men suffer from
overconfidence and trade 45 percent more than women and thereby underperform
because of higher transaction costs.
9. What is technical analysis?
10-9. A process in which analysts and market technicians examine prior price and
volume data as well as other market related indicators to determine trends that are
believed to be predictable into the future.
10. What are the views of technical analysts toward fundamental analysis?
10-10. They believe that even when important information is uncovered, it may not lead
to profitable trading because of timing considerations and market imperfections.

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Chapter 10 - Behavioral Finance and Technical Analysis

11. Outline the basic assumptions of technical analysis.

10-11. a)
b)
c)
d)
e)

Market value is determined solely by interaction of supply and demand.

Stock prices tend to move in trends that persist for long periods of time
even if there are minor fluctuations in the market.
Reversals of trends are caused by shifts in demand and supply.
Shifts in demand and supply can be detected sooner or later in charts.
Many chart patterns tend to repeat themselves.

12. Under the Dow theory, if a recovery fails to exceed the previous high and a new low
penetrates a previous low, what does this tell us about the market?
10-12. An upward pattern has come to an end.
13. Also under the Dow theory, what other average is used to confirm movements in the
Dow Jones Industrial Average?
10-13. The Dow Jones Transportation Average.
14. What is meant by a support level for a stock or a market average? When might a
support level exist?
10-14. A support level represents the lower end of a stock's normal trading range.
Support may develop each time a stock goes down to a lower level of trading
because investors who previously passed up a purchase opportunity may now
choose to act. It is a signal that new demand is coming into the market.
15. In examining Figure 97 page 220, if the next price movement is to 34, will a shift to
a new column be indicated? (Assume the current price is 36.)
10-15. Only an advance of two points or greater would cause a shift in columns. Since
the current price is 36, a price movement to 34 would represent a decline and no
shift in columns would be necessary.
16. What is the logic behind the odd-lot theory? If the odd-lot index starts to move higher
in an up market, what does the odd-lot theory indicate the next movement in the market
will be?
10-16. The odd-lot theory suggests that one watches very closely what the odd-lot trader
is doing and them proceeds to do the opposite (at key turns in the market). The
logic behind the theory is that the small trader badly misses on key market turns.

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17. If the Investors Intelligence Service has a bearish sentiment of 70
percent, would you generally want to be a buyer or seller?

10-17. Since investment advisory recommendations represent contrary opinions (tend to be

wrong), a high Bearish Sentiment of 70 percent may indicate a good time to buy.
18. What is the logic behind Barrons Confidence Index?
10-18. The logic is based on the theory that bond traders are more sophisticated than
stock traders so they pick up trends more quickly. It is computed by taking the
yield on top grade bonds and dividing by the yield on intermediate grade bonds. If
investors are optimistic about economic prosperity, the yield differential is small
and the Index is relatively high. If investors are concerned about the economy, the
yield differential is greater and the Index is lower.
19. If the advance-decline movement in the market is weak (more declines than
advances) while the DJIA is going up, what might this indicate to a technician about the
market?
10-19. The market could be going down in the future. This indicates that conservative
investors are investing in blue-chip stocks and have a lack of overall confidence
in the market. Investors are not willing to take risks on the market.
20. Categorize the following as either contrary opinion or smart money indicators (as
viewed by technicians):
a. Short sales by specialists.
b. Odd-lot positions.
c. Short sales positions.
d. Barrons Confidence Index.
e. Investment advisory recommendations.
f. Put-call ratio.
10-20. Short sales by specialists smart money
Odd-lot positions contrary opinion
Short sales positions contrary opinion
Barron's Confidence Index smart money
Investment Advisory Recommendations contrary opinion
Put/Call ratio contrary ratio

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