Chapter 7 and 8 Market Efficiency and Behavioral Finance

Technical analysis is the: study of historical prices as a means of predicting future prices
The ______ effect states that small company stocks tend to have large returns in one specific month. January
Last week, Janus Plastics announced that they had developed a new plastic container that was stronger and more durable and also easier to recycle. In response to this announcement, Janus’ stock price rose from $23 a share to a high of $36 a share and then settled back to $27 a share. This is an example of a(n):A.) Over-reaction and correlationB.) Post-activity reactionC.) Delayed reactionD.) Pre-activity actionE.) Efficient market reaction A.) Over-reaction and correlation
If the financial markets are efficient then:A.) holding a diversified, low-cost, passively-managed portfolio is probably your best investment strategy.B.) You should hire a professional money manager, regardless of the cost to do so.C.) Your investment return is highly dependent upon your security selection.D.) Having a professional manager who actively trades your portfolio is most likely your best investment strategy.E.) You should adopt an investment strategy based on market timing. A.) holding a diversified, low-cost, passively-managed portfolio is probably your best investment strategy.
The tendency of individuals to react differently to the same situation based on how the situation is presented is referred to as:A.) Mental AccountingB.) Loss AnalysisC.) Behavioral ResponsivenessD.) Frame DependenceE.) Prospect Theory D.) Frame Dependence
**Individual investors tend to: A. quickly sell their losers and buy more of their winnersB. sell their losers and hold their winnersC. suffer from loss aversion while professional money mgers. do not.D. sell winners and losers with equal frequencyE. sell winners more frequently than losers E. sell winners more frequently than losers
If the financial markets are ______ efficient, then laws prohibiting insider trading are unnecessary. strong-form
If you know info about a company which will have a significant effect on the company’s stock price once that info is released, you have knowledge that is referred to as _______ information.A. AbnormalB. Market effectC. PublicD. Material non-publicE. Excess profit D. Material non-public
If the stock market is efficient, then stocks with similar risks will:A. have similar rates of returnB. pay similar dividendsC. be priced similarlyD. produce excess returnsE. produce abnormal returns A. have similar rates of return
Peg is a contestant on a game show. At this point in the game, she can either accept $1,000 or she can throw one dart at a game board for a chance of winning $500,000. If Peg accepts the guaranteed $1,000, she is displaying _____ behavior.A. risk-takingB. prospectiveC. risk-neutralD. risk-adverseE. optimistic D. risk-adverse
An investor who trades without good info or any worthwhile financial analysis is referred as a(n):A. market timerB. noise traderC. arbiterD. sentiment traderE. market maker B. noise trader(If irrational investors act independently, they should cancel each other out– so markets would still be efficient)
For an investor to consistently “beat the market,”:A. the market would have to be in a period of excess volatilityB. the market would have to be relatively stableC. he or she would have to be excessively tradingD. the market would have to be inefficientE. he or she would have to do excessive research D. the market would have to be inefficient
Loss aversion is defined as: The hesitancy to sell a security after it has decreased in value.
The Waynard Co. announced last week that their unpopular CEO resigned. In response to this announcement, Wayward’s stock price increased from $18 a share to $23/share and he has remained constant at that level. This is an example of a(n):A. over-reaction and correctionB. pre-activity actionC. delayed reactionD. efficient market reactionE. inefficient market D. efficient market reaction
A(n) _____ is a method of research which studies the effect that news announcements have on stock prices.A. efficient hypothesisB. initial playC. market watchD. random walkE. event study E. event study
The term “independent deviations from rationality” implies that irrational investors:A.) dominate the market place.B.) independently offset the actions of rational investors.C. )behave differently from one another.D.) act together to offset the actions of rational investors.E.) guarantee an inefficient market. C. )behave differently from one another.
If the market is efficient, then the cumulative abnormal return should remain close to _____ percent.A. 100B. 0C. -10D. 50E. 10 B. 0
If you are an advocate of the odd-lot indicator, you will buy stocks when:A.) the odd-lot traders significantly increase their buying.B.) the odd-lot traders are primarily selling.C.) the odd-lot traders appear to be overly optimistic.D.) odd-lot trading volume remains relatively flat.E.) odd-lot trading volume decreases significantly. B.) the odd-lot traders are primarily selling.
The price which is expected to be the minimal value for a security is called the:A. resistance level.B. support level.C. base value.D. par value.E. reactive point. B. support level
If you believe that stock market prices follow a random walk, then:A. studying past price movements will lead to excess profits.B. having inside information will not lead to excess profits.C. you also believe the market is strong-form efficient.D. historical price information provides no benefit in predicting future prices.E. there is no financial benefit from investing in the stock market. D. historical price information provides no benefit in predicting future prices.
What looks like the pattern of a stock price and is part of the “Random Walk Hypothesis”? The Coin Toss Game-Says that stock prices are random, but they generally go UP over time.
What are the 3 key assumptions of the Efficient Market Hypothesis? 1.) Many knowledgeable investors.2.) Info is available free & at the same time.3.) Investors react quick & in an unbiased fashion to new info.
What does it mean to consistently “beat the market”? * To determine if an investment is superior to another, we need to compare excess returns (difference between what the investment earned and what other investment’s earned with similar risk. Positive excess returns=outperformed other investments with same risk earned. Thus, consistently earning a positive excess return AND on a risk adjusted basis is what we mean by “beating the market”
Which form of market efficiency says you can beat the market by looking for patterns in stock prices? None of the forms
If someone believes in the Strong Form of the Efficient Market Hypothesis, what info can they use to beat the market? None
Which form of market efficiency does not rule out beating the market by studying a company’s financial statements? Weak form
Which form of market efficiency does not rule out beating the market if you know something no one else knows? Semistrong Form
If you believe in this form of market efficiency, you don’t think anyone–not even Martha Stewart– can beat the market. Strong form
If you believe in this form of market efficiency, you still believe that people with inside info can beat the market. (two forms apply to this) Weak and Semistrong forms
My friend John works for a company that is about to buy out another company. The news isn’t public yet. I know he can’t legally buy the stock, but can I? NO! If they buy shares based on that info that is insider trading and it is illegal!
I was on a web bulletin board where there were several rumors flying around about a takeover of a company. Would it be legal for me to trade based on this info? Yes, but not smart.
What are anomalies? They are strange stock price behaviors that would seem to be in conflict with market efficiency. Hard to profit from them, though.
If markets are efficient, which of these months of the year should I expect to typically have the highest security returns? None of them. EMH says that news occurs randomly.
If the EMH holds, what day of the week should have the lowest returns? They should all be about the same. EMH says that news occurs randomly (even throughout the week)
What month of the year has been consistently a good month for Small Company Stocks? January (January Effect)
Why does the January Effect occur? Because fund managers will sell losing funds in December to try to get tax losses where they may sell securities to get bad securities off their portfolio before the end of the year. There is no Jan. effect for Large company stocks.
What day of the week, aside from the EMH saying that every day is random, has the lowest returns? Monday. Generally because companies like to announce bad news on Fridays and the news absorbs over the weekend.
What is a stock market bubble? a situation where the observed prices soar for higher than fundamentals and rational analysis would suggest
What is a stock market crash? a situation where market prices collapse significantly and suddenly.
If the market is efficient, why did Internet stocks fly so high and then crash so far and so fast (Internet-stock bubble of 1990’s)? Many people knew that the prices were inflated, but couldn’t profit based on it.
Which one is better? A. The “average” index fund such as the S&P index fundB. A long-term actively managed fundAND WHY? A. The “average” index fund such as the S&P index fund-Just being “average” gets you better returns shows that the markets are efficient, hence the EMH.
What funds with EMH believers be picking and which ones will they NOT be picking? *They will be picking Index funds with a goal of tracking the market of a particular segment of the market.*They will NOT be picking individual securities OR actively managed funds with high management fees.
What is the S&P Index? a measure of 500 leading companies that represents about 80% of the overall market capitalization of the U.S. stock exchange.
What is market capitalization? (how to calculate it & the definition) The total dollar value of its shares. Market cap=price per share *# of shares outstanding
“Superstar” investors are a matter of just plain luck according to the EMH.A. TrueB. False A. True
What are the roles of Financial Advisors? (or things to consider when choosing one or not choosing one) 1. Appropriate risk levels for each investor2. Tax considerations3. Diversification across asset categories4. Need for current income vs. capital gains
If I am looking for market inefficiencies where should I look– at large or small firms? And why? Small firms. They are less likely to have a large # of investors actively following or reading the news about the stock of the company.
If I am looking for market inefficiencies, should I look at firms with high or low Institutional (mutual funds, pension funds, etc.) ownership? and why? Firms with low institutional ownership. Institutional ownership is just ownership by mutual funds, pension funds, & companies in the like. If your looking for inefficiencies, look for the firms that haven’t been discounted by the mutual fund.
If I am looking for market inefficiencies, should I look at firms with many analysts following them or just a few, or even none? And why? Firms with Low Analyst Following the Stock.* The lower the # that are following the security, the more likely you will find inefficiencies. Securities with high # of analysts have a lot of attention, which make them more efficient.
If I believe in the EMH, which should I invest in– An actively managed fund (which tries to beat the market) or an Index fund (which tries to match the market)? Index fund. EMH believers don’t believe that you can beat the market and why should they pay fees for something that they don’t believe in? They just want to get the flow of the market in their fund.
If I believe in the EMH, which should I do: try to time moving my money in and out of the stock market or stay fully invested at all times? Stay fully invested at all times. EMH believers won’t move money in/out of stocks.

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