Term
4 errors in information processing |
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Definition
- Forecasting Errors - too much weight given to recent experience, leading to extreme forecasts
- Overconfidence - people tend to overestimate their abilities and the precision of their forecasts. Prevalence of active trading
- Conservatism - Investors are slow to update beliefs when presented with new evidence
- Sample Size neglect and representativeness - people do not take into account the size of the sample and infer patterns too quickly. favorable news leds to price run ups
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Term
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Definition
- Framing - Decisions are influenced by how they are framed. Individuals may be risk seeking in losses, and risk adverse when it comes to gains
- Mental accounting - Specific type of framing which people segregate certain decisions. Gamblers may be more risk seeking when they are winning - house money effect
- Regret avoidance - people regret decisions more if they were unconvential. leads to additional charges on "out of favor" or non-blue chip firms
- Prospect Theory - original utility curve has dimishing marginal value of wealth, new theory is loss aversion based on changes in wealth.
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Term
(3) Key limits to Arbitrage |
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Definition
- Fundamental Risk - Mispricing may get worse before it gets better
- Implementation Costs - Often Mispricing cannot be fully exploited due to transaction cost
- Model Risk - What if you are wrong? All opportunities to exploit identified mispricing will carry some risk and therefore may limit the willingness to try and exploit it fully.
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Term
Limits to the law of 1 price |
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Definition
siamese twin companies - shell and dutch petrol split profits yet price doesn't always match
Equity carve outs - palm was a subisidary of 3Com, yet was worth more
Closed end funds sell at a discount - reflecting negative alpha |
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Term
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Definition
(Price - NAV )/NAV = (α - ε )/(δ -α + ε)
α = extra return
ε = expenses
δ = dividend yield
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