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C H A P T E R
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Behavioral Finance and Technical Analysis
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25. One seeming violation of the Law of One Price is the pervasive discrepancy of closed-end fund
prices from their net asset values. Would you expect to observe greater discrepancies on diversi-
fied or less-diversified funds? Why?
Challenge
1. Don Sampson begins a meeting with his financial adviser by outlining his investment phi-
losophy as shown below:
Statement Number
Statement
1
Investments should offer strong return potential but with very limited risk.
I prefer to be conservative and to minimize losses, even if I miss out on
substantial growth opportunities.
2
All nongovernmental investments should be in industry-leading and
financially strong companies.
3
Income needs should be met entirely through interest income and cash
dividends. All equity securities held should pay cash dividends.
4
Investment decisions should be based primarily on consensus forecasts
of general economic conditions and company-specific growth.
5
If an investment falls below the purchase price, that security should be
retained until it returns to its original cost. Conversely, I prefer to take
quick profits on successful investments.
6
I will direct the purchase of investments, including derivative securities,
periodically. These aggressive investments result from personal research
and may not prove consistent with my investment policy. I have not kept
records on the performance of similar past investments, but I have had
some “big winners.”
Select the statement from the table above that best illustrates each of the following behavioral finance
concepts. Justify your selection.
a. Mental accounting.
b. Overconfidence (illusion of control).
c. Reference dependence (framing).
2. Monty Frost’s tax-deferred retirement account is invested entirely in equity securities.
Because the international portion of his portfolio has performed poorly in the past, he
has reduced his international equity exposure to 2%. Frost’s investment adviser has rec-
ommended an increased international equity exposure. Frost responds with the following
comments:
a. On the basis of past poor performance, I want to sell all my remaining international equity
securities once their market prices rise to equal their original cost.
b. Most diversified international portfolios have had disappointing results over the past 5 years.
During that time, however, the market in Country XYZ has outperformed all other markets,
even our own. If I do increase my international equity exposure, I would prefer that the
entire exposure consist of securities from Country XYZ.
c. International investments are inherently more risky. Therefore, I prefer to purchase any
international equity securities in my “speculative” account, my best chance at becoming
rich. I do not want them in my retirement account, which has to protect me from poverty in
my old age.
Frost’s adviser is familiar with behavioral finance concepts but prefers a traditional or standard
finance approach (modern portfolio theory) to investments.
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412
P A R T I I I
Equilibrium in Capital Markets
Indicate the behavioral finance concept that Frost most directly exhibits in each of his three
comments. Explain how each of Frost’s comments can be countered by using an argument from
standard finance.
3. Louise and Christopher Maclin live in London, United Kingdom, and currently rent an apartment
in the metropolitan area. During an initial discussion of the Maclins’ financial plans, Christopher
Maclin makes the following statements to the Maclins’ financial adviser, Grant Webb:
a. “I have used the Internet extensively to research the outlook for the housing market over the
next 5 years, and I believe now is the best time to buy a house.”
b. “I do not want to sell any bond in my portfolio for a lower price than I paid for the bond.”
c. “I will not sell any of my company stock because I know my company and I believe it has
excellent prospects for the future.”
For each statement (
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