Chapter 22 - Behavioral Finance: Implications for Financial Management
CHAPTER 22
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 or 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 22 - 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.
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