Banking and Finance
Topic 9
Tutorial Answers
BFC3241
Equities and Investment Analysis
Semester 2, 2018
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BFC3241 Equities and Investment Analysis
WEEK Starting LECTURE TOPIC ASSIGNED READING TUTORIAL TOPIC
1 23 Jul Assets and Investments BDBKM, Ch. 3, 5.1 to 5.2 Open Discussions
2 30 Jul Portfolio Theory BDBKM, Ch.5 (from 5.5) Assets and
and Ch.6. Investments
3 6 Aug Asset Pricing Models BDBKM, Ch. 7 Portfolio Theory
4 13 Aug Equity Analysis I – Pearce & Robinson, Ch.4 Asset Pricing
Macro and Palepu et al., Ch.2 Models
Industry Analysis Porter (2008)
5 20 Aug Equity Analysis II Palepu et al., Ch. 5 Equity Analysis I
– Financial
Statement Analysis
6 27 Aug Equity Analysis III – Palepu et al., Ch. 6 Equity Analysis II
Financial Statement
Forecasting
7 3 Sep Equity Analysis IV – Palepu et al., Ch. 7 Equity Analysis III
Valuation BDBKM, Ch. 11
Implementation
8 10 Sep Market Efficiency and BDBKM, Ch. 8 Equity Analysis IV
Behaviour Finance I
9 17 Sep Market Efficiency and BDBKM, Ch. 8 Market Efficiency
Behaviour Finance II Nofsinger and Behaviour
Finance I
Mid Semester Break
10 1 Oct CFA Code of Ethics and CFA Standards of Practice Market Efficiency
Standards of Handbook and Behaviour
Professional Conduct Finance II
11 8 Oct Portfolio Management BDBKM, Ch. 16, 17 CFA Code of Ethics
–I and Standards of
12 15 Oct Portfolio Management BDBKM, Ch. 18 Portfolio
– II Management I
SWOT 22 Oct Portfolio
– VAC Management II
(Self Revision)
Mid Sem Break Mid Sem Test Group Presentations
Students are required to prepare answers for all questions. Due to time constraints, students are
encouraged to nominate the questions/problems for discussion at the commencement of each
tutorial. Solutions for all questions will be made available on Moodle at the end of each week.
Tutorial 9 Week 10 –Market Efficiency & Behavioural
Finance II
Note: Flipping Class & Group Activities
Students are expected to have attended the lecture and have done the required readings
assigned for topics 8 and 9 on market efficiency and behavioural finance. In tutorial 9
(week 10), students work in groups on biases of students’ choice from the list below:
Availability Heuristic Endowment Effect
Representative Heuristic Status Quo Bias
Loss Aversion and Prospect Self-attribution Bias
Theory Overconfidence
Mental Accounting Confirmation Bias
Regret Social Herding
Hindsight Bias
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Answer: The key concept and one finance-related example are provided below for each
psychological bias. For details, refer to the readings assigned to this topic and the
lecture recording.
1. Availability heuristic:
The likelihood of an event depends on how easily it can be brought to
mind, remembered or imagined.
Events which are salient (i.e. vivid, familiar, concrete, recent, unusual, or
highlighted by the media) are easily recalled or imagined, and their
likelihood is overestimated.
Finance-related example: Local bias in portfolio holdings.
2. Representative heuristic:
Judgments based on stereotypes
How representative of, or similar to, the underlying category or process
is the predicted event?
Other factors that affect such judgments are frequently ignored.
Finance-related example: “Good firm good stock” syndrome
3. Loss Aversion and Prospect Theory:
Investors do not mentally mark-to-market, key reference point in their
investment frame is the original purchase price.
Their utility level is therefore a function of gains or losses rather than
wealth.
The ability to tolerate loss is a key determinant of all financial decision
making
Prospect theory (Kahneman and Tversky, 1979) says “losses loom larger
than gains”. A loss has about two and a half times the impact of a gain of
the same magnitude.
Finance-related example: “Get-evenitis” mentality (i.e. trying to break-
even)
4. Mental accounting:
Investors create independent mental accounts which may belong to the
same ‘account’ in a rational world.
Finance-related example: “Don’t dip into capital” advice divides return
into dividend account vs. Capital gain account. These are parts of total
returns and are substitutable.
5. Regret:
Investors develop the feeling of guilt, regret and shame They suffer
the pain of not only the losses but the responsibility for those losses.
Hence the development of strategies to minimize anticipated regret
Finance-related example: To avoid the feeling of regret, allocating 50%-
50% to bonds and equities instead of using portfolio optimization.
6. Hindsight bias:
Considering the events that happened as much more inevitable than they
looked before the fact
(Other people) past decisions may look wrong, whereas they were perfectly
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reasonable given the information set available at the time
Finance-related example:
7. Endowment effect:
People place a higher value on things that they own just because of the
ownership.
Finance-related example: One reason why investors tend to hold on to
losers for too long (the disposition effect) is because they place a higher
value on loser stocks due to their ownership
8. Status quo bias:
The tendency to stay with the default option (not making any change to
the current status).
The more complex the decision is, the more likely the status quo bias
Finance-related example: even finance educated investors tend to stay
with their superannuation default option.
9. Self-attribution bias:
Successes are attributed to skill while failure is caused by bad luck.
Finance-related example: following some success (e.g. forecast is close
to the actual figure), analysts tend to attribute the success to their own
skills and place more emphasis on private information rather than public
information.
10. Overconfidence:
We systematically overestimate our decision making abilities compared
with what objective circumstances would warrant
The greater the level of skill required and the more complex the task, the
more confident we are in our abilities and judgment
Overconfidence causes people to overestimate their knowledge,
underestimate risks, and exaggerate their ability to control events.
Finance-related example: Investors tend to become overconfident with
investment decisions that are more complicated such as investing in
IPOs versus currently listed stocks.
11. Confirmation Bias:
We see what we want to see and interpret evidence in terms of our
perceived notions.
Finance-related example: Analysts with pre-perception on a firm may
work with many profitability measures to confirm their pre-perception
when judging the firm’s performance.
12. Social herding:
Social herding is rooted from the need for conformity as we are part of
social collective.
Finance-related example: Traders (Analysts) tend to follow the crowd
when making investment decision (investment recommendations).
Q.2.
Jill Davis tells her broker that she does not want to sell her stocks that are below the price
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she paid for them. She believes that if she just holds on to them a little longer, they will
recover, at which time she will sell them. What behaviour characteristic does Davis have as
the basis for her decision making?
a. Loss aversion
b. Conservatism
c. Representativeness
Answer:
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.
Q.3
After Polly Shrum sells a stock, she avoids following it in the media. She is afraid that it
may subsequently increase in price. What behavioural characteristics does Shrum have as
the basis for her decision making?
a. Regret avoidance
b. Representative
c. Overconfidence
Answer:
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.
Q.4
Match each example to one of the following behavioural characteristics:
Example Characteristic
a. Investors are slow to update their beliefs when given new i. Disposition effect
evidence
b. Investors are reluctant to bear losses caused by their ii. Conservatism bias
unconventional decisions
c. Investors are reluctant to sell stocks with “paper” losses iii. Representative bias
d. Investors disregard sample size when forming views about the iv. Regret avoidance
future from the past
Answer:
a – ii
b – iv
c–i
d – iii