Explain how some of the behavioral biases discussed in the chapter might contribute to the successof technical trading rules.

A number of the behavioral biases discussed in the chapter might contribute to such trends and patterns. For example, a conservatism bias might contribute to a trend in prices as investors gradually take new information in to account, resulting in gradual adjustment of prices towards their fundamental values.

Explanation:

Step by step explanation:

1. Technical analysis can generally be viewed as a search for trends or patterns in market prices. Technical analysts tend to view these trends as momentum, or

gradual adjustments to ‘correct’ prices, or, alternatively, reversals of trends. A number of the behavioral biases discussed in the chapter might contribute to such trends and patterns. For example, a conservatism bias might contribute to a trend in prices as investors gradually take new information into account, resulting in gradual adjustment of prices towards their fundamental values. Another example derives from the concept of representativeness, which leads investors to inappropriately conclude, on the basis of a small sample of data, that a pattern has

been established that will continue well into the future. When investors

subsequently become aware of the fact that prices have overreacted, corrections reverse the initial erroneous trend.

2. Even if many investors exhibit behavioral biases, security prices might still be set efficiently if the actions of arbitrageurs move prices to their intrinsic values. Arbitrageurs who observe mispricing in the securities markets would buy

underpriced securities (or possibly sell short overpriced securities) in order to profit from the anticipated subsequent changes as prices move to their intrinsic values.

Consequently, securities prices would still exhibit the characteristics of an efficient market.

3. One of the major factors limiting the ability of rational investors to take advantage of any ‘pricing errors’ that result from the actions of behavioral investors is the fact

that a mispricing can get worse over time. An example of this fundamental risk is the apparent ongoing overpricing of the NASDAQ index in the late 1990s. A

related factor is the inherent costs and limits related to short selling, which restrict the extent to which arbitrage can force overpriced securities (or indexes) to move

towards their fair values. Rational investors must also be aware of the risk that an apparent mispricing is, in fact, a consequence of model risk; that is, the perceived

mispricing may not be real because the investor has used a faulty model to value the security

4. There are two reasons why behavioral biases might not affect equilibrium asset

prices: first, behavioral biases might contribute to the success of technical trading

rules as prices gradually adjust towards their intrinsic values, and second, the

actions of arbitrageurs might move security prices towards their intrinsic values. It

might be important for investors to be aware of these biases because either of these

scenarios might create the potential for excess profits even if behavioral biases do

not affect equilibrium prices.

In addition, an investor should be aware of his personal behavioral biases, even if

those biases do not affect equilibrium prices, to help avoid some of these

information processing errors (e.g. overconfidence or representativeness).

5. Efficient market advocates believe that publicly available information (and, for

advocates of strong-form efficiency, even insider information) is, at any point in

time, reflected in securities prices, and that price adjustments to new information

occur very quickly. Consequently, prices are at fair levels so that active

management is very unlikely to improve performance above that of a broadly

diversified index portfolio. In contrast, advocates of behavioral finance identify a

number of investor errors in information processing and decision making that could

result in mispricing of securities. However, the behavioral finance literature

generally does not provide guidance as to how these investor errors can be exploited

to generate excess profits. Therefore, in the absence of any profitable alternatives,

even if securities markets are not efficient, the optimal strategy might still be a

passive indexing strategy.

6. a. Davis uses loss aversion as the basis for her decision making. She holds on to

stocks that are down from the purchase price in the hopes that they will recover.

She is reluctant to accept a loss.

7. a. Shrum refuses to follow a stock after she sells it because she does not want to

experience the regret of seeing it rise. The behavioral characteristic used for the

basis for her decision making is the fear of regret.

8. a. Investors attempt to avoid regret by holding on to losers hoping the stocks will

rebound. If the stock rebounds to its original purchase price, the stock can be sold

with no regret. Investors also may try to avoid regret by distancing themselves from their decisions by hiring a full-service broker.