978-0134083308 Chapter 9 Solution Manual Part 1

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Chapter 2 Securities Markets and Transactions 15

Chapter 9

Market Efficiency and Behavioral Finance

 Outline

Learning Goals

I. Efficient Markets

A. The Efficient Markets Hypothesis

1. Weak Form

2. Semi-Strong Form

3. Strong Form

4. Arbitrage and Efficient Markets

B. Market Anomalies

1. Calendar Effects

2. Small-Firm Effect

3. Post Earnings Announcement Drift (or Momentum)

4. The Value Effect

C. Possible Explanations

II. Behavioral Finance: A Challenge to the Efficient Markets Hypothesis

A. Investor Behavior and Security Prices

1. Overconfidence and Self-Attribution Bias

2. Loss Aversion

3. Representativeness

a. Overreaction

b. Underreaction

4. Narrow Framing

5. Belief Perseverance

6. Anchoring

7. Familiarity Bias

B. Implications of Behavioral Finance for Security Analysis

Concepts in Review

III. Technical Analysis

A. Measuring the Market

1. The confidence Index

2. Market Volume

16 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition

3. Breadth of the Market

4. Short Interest

5. Odd-Lot Trading

B. Trading Rules and Measures

1. Advance-Decline Line

2. New Highs–New Lows

3. The Arms Index

4. Mutual Fund Cash Ratio

5. On-Balance Volume

6. Relative Strength

F. Charting

1. Chart Formations

2. Moving Averages

Concepts in Review

Summary

Key Terms

Discussion Questions

Problems

Case Problems

9.1 Brett Runs Some Technical Measures on a Stock

9.2 Deb Takes Measure of the Market

Excel@Investing

 Key Concepts

1. The idea of random walks and efficient markets, particularly with regard to how the efficient

market concept explains why prices move randomly, and cautioning the investor not to expect to

consistently outperform the market

2. Weak, semi-strong, and strong versions of the efficient market hypothesis and market anomalies

3. Behavioral finance as a challenge to market efficiency and how psychological factors can affect

investors’ decisions

4. Technical analysis, its role in the security analysis and stock selection process, and the various

measures of market performance that make up technical analysis

 Overview

The efficiency of stock market prices is considered in this chapter. Information is divided into three

categories—price and volume, fundamental data, and information known only to insiders. Market

efficiency is examined at each level, along with some pieces of information that seem to provide returns in

excess of what would be expected solely on the basis of risk. Emotions and other subjective factors play a

role in investment decisions. Hence, this chapter includes information on the new area of behavioral

finance so that readers can appreciate the ongoing debate between behaviorists and supporters of the

efficient market hypothesis.Various techniques for analyzing past patterns in the stock market are known

Chapter 2 Securities Markets and Transactions 17

collectively as technical analysis.Because technical analysis uses past prices and other public information

to predict future prices, it is at odds with all forms of the efficient market hypothesis.

1. The efficient market hypothesis (EMH) is described. The different levels of market efficiency

based on the type of information that is incorporated into market prices are also described. Usually

students are curious to know which of the various theories best explains the “real world.” The

instructor may expect some lively classroom interchange on this, especially if the implications for

technical and fundamental analysis are presented.

2. The different levels of market efficiency, based on the type of information that is incorporated into

market prices, are also described.

3. Market anomalies that call into question the EMH are identified. Calendar effects, the small-firm

effect, the post earnings announcement drift, and the value effect are described as challenges to the

efficient pricing of securities. Possible explanations are then given. This section definitely invites

student participation, and a healthy debate is a great motivator at this point in the course.

4. Coverage of the behavioral finance segment of the chapter is best done through a discussion of the

factors that students see impacting investor decisions. Those frequently mentioned include

overconfidence, biased self-attribution, and loss aversion. This tends to be one of the chapters that

students greatly enjoy.Students who have taken classes in psychology or sociology may be asked to

contribute insights from those disciplines and whether or not they think that the model of behavior

portrayed by the efficient market hypothesis is consistent with what they have studied elsewhere.

5. Technical analysts develop trading rules based on mathematical equations and measures as a way

to assess market conditions. Among the most widely used technical indicators are the

advance-decline line, new highs–new lows, Arms Index, mutual fund cash ratio, and on balance

volume (OBV).It is usually best to bring current levels of these measures to class.

6. The Confidence Index is discussedas an example of a technical indicator that provides insight into

general stock market conditions.

7. Another technical analysis approach is that of measuring variables that drive market behavior.

Technical indicators such as market volume,breadth of the market, mutual fund cash ratio, short

interest,and odd-lot trading are covered among several other indicators.

8. Charting is discussed next. Details about different types of charts (bar charts, point-and-figure

charts, and chart formations) are best explained with visual examples.The instructor may want to

introduce students to some of the many websites devoted to technical analysis and charting.

 Answers to Concepts in Review

9.1 The random walk hypothesis claims that stock prices follow a random or erratic pattern.

An efficient market is one in which the market price of the security always fully reflects all available

18 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition

9.2 To outperform the market consistently, one must be able to consistently find stocks selling

below their justified prices.By purchasing those stocks and holding themuntil they adjust upward to

a. In an efficient market there is a tradeoff between risk and return.Investors can earn higher returns

b. Investors can earn high rates of return temporarily just by being lucky.To earn high returns

9.3 Market anomalies are deviations from what one would expect in an efficient market and,

hence, refute the efficient market hypothesis. Most of these anomalies are empirical anomalies,

a. The January effect is the term applied to the tendency for small stocks to earn higher returns than

b. The size effect is the term applied to the tendency for investments in the common stock of small

9.4 Beyond firm fundamentals, behavioral finance advocates believe that investors’ decisions

are affected by a number of cognitive biases.. These biases causeinvestors to overreact to some types

9.5 a. Behavioral finance observes that overconfidence is a common trait. Investors who

are overconfident may trade too often, thinking that they are skilled at identifying undervalued

Chapter 2 Securities Markets and Transactions 19

b. Behavioral finance suggests that investors are too inclined to believe that past trends will

continue.Thus, they believe that stocks that have had several good years (e.g., growth stocks) will

The fundamental point here is that past trends do not do a very good job of predicting future

performance, but many investors act as if they do not believe that this is true.There are several

c. The cognitive bias known as representativeness can sometimes cause investors to under react to

new information, particular new information that is extreme (i.e., very good or very

9.6 Technical analysis involves the study of historical stock prices, returns, and trading

volume to (hopefully) identify repeating patterns that investors may exploit to earn higher returns.

9.7 The market can definitely have an impact on the prices of individual securities, and a

significant one at that. In fact, studies have indicated that between 20% and 50% of stock price

9.8 The Confidence Index is the ratio of the average yield on high-grade corporate bonds to

20 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition

9.9 a. The breadth of the market measure contrasts the number of firms with share price

b. Short interest is a measure of the number of shares in the stock market that have been sold short.

c. Odd-lot trading is based on the cynical assumption that small investors will be the last to invest

in a bull market and the last to sell in a bear market. Hence, as the number of odd-lot purchases

9.10 a. An advance-decline line is the difference between the number of shares going up in price

and the number going down in price. The NYSE, Amex, and Nasdaq publish statistics on how

many of

b. The Arms Index builds on the advance-decline line by considering the volume in advancing and

c. On balance volume (OBV) is a momentum indicator that relates volume to price change. When

the security closes higher than the previous day, all the day’s volume is considered up volume

d. The relative strength index (RSI) is a measure of the average price change on up days to the

e. Moving averages compare current share price to the average share price over a specified period.

9.11 A stock chart is simply a historical record (or “picture”) of the behavior of a stock, the market, or

some technical measure (like short interest). Chartists believe that price patterns evolve into chart

formations, which provide signals about the future course of the market or a particular stock.

Chapter 2 Securities Markets and Transactions 21