Chapter 26 - Behavioral Finance: Implications for Financial Management
CHAPTER 26
BEHAVIORAL FINANCE:
IMPLICATIONS FOR FINANCIAL
MANAGEMENT
Answers to Concepts Review and Critical Thinking Questions
1.
The least likely limit to arbitrage is firm-specific risk. For example, in the 3Com/Palm case, the
stocks are perfect substitutes after accounting for the exchange ratio. An investor could invest in a
risk neutral portfolio by purchasing the underpriced asset and selling the overpriced asset. When the
prices of the assets revert to an equilibrium, the positions could be closed.
2.
Overconfidence is the belief that one’s abilities are greater than they are. An overconfident financial
manager could believe that they are correct in the face of evidence to the contrary. For example, the
financial manager could believe that a new product will be a great success (or failure) even though
market research points to the contrary. This could mean that the company invests too much in the
new product or misses out on the new investment, an opportunity cost. In each case, shareholder
value is not maximized.
3.
Frame dependence is the argument that an investor’s choice is dependent on the way the question is
posed. An investor can frame a decision problem in broad terms (like wealth) or in narrow terms
(like gains and losses). Broad and narrow frames often lead the investor to make different choices.
While it is human nature to use a narrow frame (like gains and losses), doing so can lead to irrational
decisions. Using broad frames, like overall wealth, results in better investment decisions.
4.
A noise trader is someone whose trades are not based on information or financially meaningful
analysis. Noise traders could, in principle, act together to worsen a mispricing in the short-run. Noise
trader risk is important because the worsening of a mispricing could force the arbitrageur to liquidate
early and sustain steep losses.
5.
As long as it is a fair coin the probability in both cases is 50 percent as coins have no memory.
Although many believe the probability of flipping a tail would be greater given the long run of
heads, this is an example of the gambler’s fallacy.
6.
Taken at face value, this fact suggests that markets have become more efficient. The increasing ease
with which information is available over the Internet lends strength to this conclusion. On the other
hand, during this particular period, large-capitalization growth stocks were the top performers.
Value-weighted indexes such as the S&P 500 are naturally concentrated in such stocks, thus making
them especially hard to beat during this period. So, it may be that the dismal record compiled by the
pros is just a matter of bad luck or benchmark error.
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Chapter 26 - Behavioral Finance: Implications for Financial Management
7.
The statement is false because every investor has a different risk preference. Although the expected
return from every well-diversified portfolio is the same after adjusting for risk, investors still need to
choose funds that are consistent with their particular risk level.
8.
Behavioral finance attempts to explain both the 1987 stock market crash and the Internet bubble by
changes in investor sentiment and psychology. These changes can lead to non-random price
behavior.
9.
Behavioral finance states that the market is not efficient. Adherents argue that: (a) Investors are not
rational. (b) Deviations from rationality are similar across investors. (c) Arbitrage, being costly, will
not eliminate inefficiencies.
10. Frame dependence means that the decision made is affected by the way in which the question is
asked. In this example, consider that the $78 is a sunk cost. You will not get this money back
whether or not you accept the deal. In this case, the values from the deal are a gain of $78 with 20
percent probability or a loss of $22 with an 80 percent probability. The expected value of the deal is
$78(.20) – $22(.80) = –$2. Notice this is the same as the difference between the loss of $78 and the
expected loss of $80 which we calculated using no net loss and a loss of $100.
Solutions to Questions and Problems
1. (LO1-3) John is experiencing over confidence and over optimism in the fact that he has assumed
that the average rate of growth in the housing sector will continue. He also assumes that his
house falls into the same category as the general 7% growth population and due to demographics
his location may not be as desirable as other more popular areas. In reality he should do some
more investigating.
2. (LO1-3) Pamela is experiencing over optimism and affect heuristic. She is pretty confident in her
ability to first of all choose RIM and secondly seems to instinctively believe that RIM will
rebound. She didn’t make a decision based on sound analysis but more so hoping that RIM will
rebound. Nortel Networks is probably one on Canada’s most notable example of poor decision
making by many people and not doing their homework in analysis.
3.
(LO1-3) Forest Gump is treating investing like “a box of chocolates” as he never knows what
he’s going to get in reality. His comment that he needs a steady stream of income after he retires
leads one to think that he should be more conservative with his investments. He is overconfident
in his abilities to choose wisely and is not necessarily making sound judgement based on analysis.
Therefore he is also showing the behavior of affect heuristic.
4. (LO1-3) Jack Sparrow is displaying the behavior of loss aversion or “break-evenitis”. He is
unwilling to accept a loss on his Facebook shares even though the true value is lower than the
purchase price. He also showed a lot of overconfidence and affect heuristic as he truly believed
and was caught up in the NOISE of Facebook’s IPO. He should never have bought based on the
information he DIDN’T have. Further analysis was definitely warranted.
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Chapter 26 - Behavioral Finance: Implications for Financial Management
5. (LO1-3) Sharon is experiencing bias towards the company that she works for. She is over
confident in her assessment of IMAX and due to her bias within the company may be making an
incorrect decision. She doesn’t likely know the full picture of IMAX’s financial position and is
relying on her instincts rather than actual financial information. This is affect heuristic behavior.
6. (LO1-3) Matthew Fleming is experiencing confirmation bias in that he is confirming that his
ability to pick winners is based on skill alone when in fact it was based on something that was not
in his control at all with the new reserves found. Stephen Fleming is experiencing Self
Attribution behavior as he has stated that it was something that was not his fault for the losses
incurred and strictly “bad luck”.
7. (LO1-3) Lucy Smith is experience aversion to ambiguity as she is unable to find information
about a company handily on the internet. Telus a large company obviously would be well know
on the Net whereas the other company would likely entail some further digging and ultimately
she should do further analysis to determine if Either company is worthy of investing into. She
could experience opportunistic losses by not investing in Seair.
8. (LO1-3 Jenna Simpson is experiencing Myopic loss aversion. She is worried too much about the
short term losses and should be focusing on the long term potential gains she might occur. The
question ultimately when it comes to investing is time horizons. She should focus on the long
term gains that she could make. Ultimately no one knows for sure where the Bottom and Top is
exactly for stocks so it comes down to making a decision based on long term planning and sound
financial analysis.
9. (LO4) Apple would likely increase in value on the NASDAQ simply based on the NOISE and
SENTIMENT. Most people would make this decision solely based on the fact that they know
APPLE and with the announcement of the new product would expect to see stock prices increase
and thus would jump in and buy based solely on these HUNCHES. Problem is that they are
lacking sound analysis of the fundamentals of the company itself. What will happen is that the
smart investors that do proper analysis will help maintain some form of market efficiency as the
price of the stock will eventually reflect the true value as they determine the price based on ALL
the pertinent information available.
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