Chapter 7 Financial Markets: Risk and Investment

Question 1

Efficient market hypothesis

Answer 1

all of the information available at a given time should be reflected in the price of the traded securities

Question 2

Noise traders

Answer 2

– do not behave rationally, but instead do not take some information into account, place too much value on rumours, and make many more trades than would be the case among rational traders

Question 3

Passive investors

Answer 3

– do not behave rationally, but instead make purchases and then do not trade again for a long time, and make much fewer trades than would be the case among rational traders

Question 4

Investor mistakes

Answer 4

1. Pride: the sin of overconfidence in one’s forecasts
2. Gluttony: the sin of accumulating information and the illusion of knowledge
3. Lust: the sin of believing information from company executives or fund managers
4. Envy: the sin of excessive self-confidence
5. Greed: the sin of hyperactivity
6. Sloth: the sin of credulity
   Wrath: the sin of group decision-making

Question 5

Disposition effect

Answer 5

– investors hold on to losing stocks for too long, and sell winning stocks too quickly

• Prospect theory: buying price as a reference point; more risk-seeking in loss Domain
• Reluctance to sell losing stock: disposition effect becomes smaller when participants are forced to sell after each round with the option to rebuy

• Disposition effect is lower among
– wealthy investors and professional stock traders
– more intelligent and experienced Traders

• Disposition effect can be reduced by
– positive mood
– self-control
– learning about other investors’ outcomes

Question 6

House money effect

Answer 6

– previous gains can lead to greater risk seeking

• Stock traders sometimes do not yet consider the recently earned profits from stock sales to be their own money; easier to take greater risks

Question 7

Starting low but ending high effect

Answer 7

– in auctions, low starting prices can lead to high final Prices

• Reasons:
– reduced entry barriers: low starting prices encourage participation in auctions and stock purchasing
– sunk costs: low starting prices entice bidders to invest time and energy in the auction or market, and to continue due to sunk cost effects
– brisk(rege) participation: bidders might conclude that particularly valuable goods are at stake, which makes them willing to pay a higher price

Question 8

Home bias

Answer 8

– investors tend to select stocks from their own Country
– therefore ignore that the values of these stocks correlate more closely with one another than do the values of stocks from different countries

Question 9

Incidental affect

Answer 9

emotions and moods that are experienced at the time of decisionmaking but have no connection to the task at hand

Question 10

Integral affect

Answer 10

emotions and moods that are directly linked to the decision itself

– anticipated emotions: concern the consequences of a decision (e.g., delight, disappointment)
– anticipatory emotions: concern the immediate visceral reactions to risk in a decision (e.g., dread(Furcht), anxiety)

Question 11

Herd behaviour

Answer 11

– tendency among investors to follow the behaviour of other investors blindly

• Conformity with the crowd in buying and selling stocks, even when facts do not give good reasons

Question 12

Information cascades

Answer 12

investors ignore their private information and imitate others

Question 13

Speculative bubble

Answer 13

– a situation where a large difference between the market price of an investment and its fundamental value occurs

Question 14

Mechanisms responsible for the development of speculative bubbles

Answer 14

– financial contagion spread of speculative bubbles via physical cash flows in the international and global trade of goods

– mutual psychological contagion similar to the way an infectious disease spreads, investors´ emotions, attitudes and expectations ‘infect’ others

– psychological escalation similar to feedback on a microphone: external trigger (e.g., a media report) generates interest among investors; some purchase the stock; therefore, price increases; media reports on price increases generate even more interest among investors; …

Question 15

Wisdom of the crowd

Answer 15

– a statistical effect where an aggregate collective judgment is more accurate than individual judgments

• Importantly, investing often is not independent: Process of herding usually initialized by influential people, institutions and media outlets

Question 16

Reason-based vs implicit trust

Answer 16

• Reason-based trust
– reflective processes
– based on perception to depend on another party to achieve a specific goal, evaluation of the trustee’s willingness and ability to achieve the specific goal, specific opportunities or hindrances

• Implicit trust
– automatic and unintentional processes
– based on perception of similarity between the trustor and trustee, shared social identity, and shared values

Question 17

Bases for trust in financial institutions

Answer 17

• Competence: factual grasp of products, knowledge of clients’ risk appetite
• Integrity: advertising honestly and with care
• Transparency: clear language, communicating rules and procedures
• Benevolence: consider clients’ interests
• Value congruence: fit between values held (gehaltenen Werten)by financial institutions and their clients
• Stability: work to ensure continuous and longterm Returns
• Reputation: positive image, previous achievements