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Fifth Edition




648 Part SIX Active Investment Management


10. Project your Social Security benefits with the parameters of Section 18.6.
11. Using Spreadsheet 18.10, assess the present value of a 1% increase in college tuition as
a fraction of the present value of labor income.
12. Give another example of adverse selection.
13. In addition to expected longevity, what traits might affect an individual™s demand for a
life annuity?
14. Give another example of a moral hazard problem.



WEBMA STER

Retirement Calculator
As was discussed in Chapters 17 and 18 one of the major factors that affects invest-
ment performance is asset allocation. A retirement calculator that allows you to spec-
ify different allocations and different levels of desired income to test the ability to meet
your retirement goals is available at http://www3.troweprice.com/retincome/RIC. Use
the calculator to answer the following questions:
1. What level of retirement assets will you need to support a retirement income
level of $7,000 per month with 90% certainty? Assume that you will retire when
you are 60, you expect to live for 30 years after you retire, and your portfolio
allocation is 60% stock, 30% bonds, and 10% cash. Work in increments of
$100,000 in retirement assets.
2. How much would you need to have in retirement assets to meet the same goal
with a 99% certainty?
3. If you return to the original 90% certainty level, how much would you need in
retirement assets to meet your original goal with a 40% stock, 40% bond, and
20% cash allocation?




SOLUTIONS TO 1. When ROR falls by 1% to 5%, the retirement annuity falls to from $192,244 to $149,855 (i.e., by
22.45%). To restore this annuity, the savings rate must rise by 4.24 percentage points to 19.24%.
>
Concept With this savings rate, the entire loss of 1% in ROR falls on consumption during the earning years.
CHECKS 2. Intuition suggests you need to keep the real rate (2.91%) constant, that is, increase the nominal rate
to 7.03 (confirm this). However, this will not be sufficient because the nominal income growth of
7% has a lower real growth when inflation is higher. Result: You must increase the real ROR to
compensate for a lower growth in real income, ending with a nominal rate of 7.67%.
3. There are two components to the risk of relying on future labor income: disability/death and career
failure/unemployment. You can insure the first component, but not the second.
www.mhhe.com/bkm




4. Holding before-tax income constant, your after-tax income will remain unchanged if your average
tax rate, and hence total tax liability, is unchanged:
Total tax (Income Exemption) Tax rate, or T (I E) t

A 1% increase in the tax rate will increase T by .01(I E). A 1% increase in the exemption will
decrease T by .01 E t. Realistically, I E will be greater than E t and hence you will be
worse off with the increase in exemption and tax rate.
5. The qualitative result is the same. However, with no shelter you are worse off early and hence lose
also the earning power of the additional tax bills.
Bodie’Kane’Marcus: VI. Active Investment 18. Taxes, Inflation, and © The McGraw’Hill
Essentials of Investments, Management Investment Strategy Companies, 2003
Fifth Edition




649
18 Taxes, Inflation, and Investment Strategy


6. No, an increase in the low-bracket tax rate applies to your entire taxable income, while an increase
in the high-bracket tax rate applies only to a fraction of your taxable income.
7. No, in your hypothetical case, the Roth IRA tax shelter produces less taxes yet a smaller real
retirement annuity. The reason is the timing of the taxes. The timing issue does not affect the
stream of tax revenues to the IRS because at any point in time, taxpayers are distributed over all
ages. In this case, the IRS can replace all Roth IRAs with traditional IRAs and lower the tax rates.
The IRS will collect similar revenue each year, and retirees will enjoy higher real retirement
annuities.
8. No, in terms of cash income, preferred stocks are more similar to bonds.
9. Your projected retirement fund is risky because of uncertainty about future labor income and
future real returns on savings. The projected Social Security real annuity is risky because of
political uncertainty about future benefits. It™s hard to judge which risk is greater.
10. You can invest in savings accounts that yield a floating rate tied to an index of college tuition.
11. A fixed-rate mortgage is the lower risk, higher expected cost option. Homeowners with greater
risk tolerance might opt for a variable-rate mortgage which is expected to average a lower rate
over the life of the mortgage.
12. In the old days, children were more than a bundle of joy; they also provided a hedge for old-age
income. Under such circumstance, insuring children would make economic sense. These days,
children may well be a financial net expenditure, ruling out insurance on economic grounds. Other
nonfinancial considerations are a matter of individual preference.
13. Rushing into marriage for economic reasons is a very risky proposition. A bad marriage can be a
financial, as well as an emotional, calamity.




www.mhhe.com/bkm
Bodie’Kane’Marcus: VI. Active Investment 19. Behavioral Finance and © The McGraw’Hill
Essentials of Investments, Management Technical Analysis Companies, 2003
Fifth Edition




19
BEHAVIORAL FINANCE
AND TECHNICAL
ANALYSIS


AFTER STUDYING THIS CHAPTER
YOU SHOULD BE ABLE TO:


> Understand the principles of behavioral finance.



> Identify reasons why technical analysis may be profitable.



> Use the Dow theory to identify situations that technicians
would characterize as buy or sell opportunities.



> Use indicators such as volume, put/call ratios, breadth,
short interest, or confidence indexes to measure the
“technical conditions” of the market.




650
Bodie’Kane’Marcus: VI. Active Investment 19. Behavioral Finance and © The McGraw’Hill
Essentials of Investments, Management Technical Analysis Companies, 2003
Fifth Edition




Related Websites http://www.thegumpinvestor.com/stocks/
technical_analysis/default.asp
http://www.decisionpoint.com
This site provides information on charting and other
This site is directed toward technical analysis.
technical indicators.
http://bigcharts.marketwatch.com
http://finance.yahoo.com
The above site gives you substantial capabilities to
This site has extensive charting capability along with
chart stocks and compare them to trends and other
information on many technical indicators.
market variables.
http://www.firstcap.com
This site offers free information and also subscription
services. It features many technical trading tools.




he Capital Asset Pricing Model (CAPM) explains security prices by assuming

T rational behavior on the part of investors. Components of this behavior, like
mean-variance optimization, suggest investors must be able to solve compli-
cated equations to construct optimal portfolios. Obviously, this assumption is unreal-
istic. The standard response to this criticism is that a large number of investors
intuitively behave in a reasonable way which, on average, is similar to mean-variance
optimization. Yet observations cannot confirm that this is the case either. The Arbi-
trage Pricing Theory (APT) provides another line of defense for the idea that rational
behavior will dominate capital asset price formation. This theory proposes that it will
take few professionals deploying large investment funds to dominate price formation
in security markets. The evidence of persistent anomalies in asset prices, as cata-
logued in Chapter 8, leaves us with a conundrum: Are these anomalies just sampling
phenomena, are they driven by institutional trade friction, or are they a result of per-
sistent, widespread behavior that is inconsistent with the assumption of economic
theory? Behavioral finance is a growing specialization in pursuit of a coherent theory
that explains market anomalies. We describe some of the major tenets of this emerg-
ing theory at the top of the chapter.
Regardless of origin, as long as anomalies in asset pricing persist, technical
analysis may be considered a defensible tool to exploit observed, inefficient prices. As
such, technical analysis is part of the study of active portfolio management. Its test is
in its ability to generate abnormal profits in this pursuit. Technical analysis focuses
more on past price movements of a company or an index than on the underlying
fundamental determinants of future profitability. Technicians believe that past price
and volume data signal future price movements. As we lay out the basics of technical
analysis in the second part of this chapter, we point out the contradictions be-
tween the assumptions on which these strategies are based and the notion of well-
functioning capital markets with rational and informed investors.
Bodie’Kane’Marcus: VI. Active Investment 19. Behavioral Finance and © The McGraw’Hill
Essentials of Investments, Management Technical Analysis Companies, 2003
Fifth Edition




652 Part SIX Active Investment Management


19.1 WHAT IS BEHAVIORAL FINANCE?
The premise of behavioral finance is that conventional financial theory ignores people, and
that people make a difference. Supporters suggest one reason for this failure is that data on
prices and returns are easy to come by but studying behavior is more difficult. The objective
of behavioral finance is to consider all explanations in the search for understanding security
returns.
The search for explanations of price series that stand in contradiction to conventional mod-
els is difficult. As in any science, new theories come up short on occasion and often remain
controversial for some time. We point out such examples in the field of behavioral finance. Yet
a field of science should never be judged a failure as long as its reason for being”explaining
puzzling data”is still valid. Behavioral finance is an infant science, yet it is important for
anyone interested in finance to be knowledgeable about its essential developments.

19.2 INDIVIDUAL BEHAVIOR
One of the major tenets of rational behavior is selfishness. This is to say that the individual
attempts to maximize his or her own welfare, with little attention paid to others™ welfare. Yet
even casual observations confirm that this is not the case. The summary provided here draws
heavily on Thaler (1992, 1993).

Cooperation and Altruism
We begin our analysis of cooperation with the famous “prisoner™s dilemma.” Two felons are
caught and separated from each other. If both refuse to confess, they can be convicted on only
minor charges and will each receive a one-year sentence. If both confess, each will receive a
sentence of five years. If only one confesses and gives evidence against the other, he goes free
and the other receives a 10-year sentence. Examination of the possible outcomes shows that
the dominant strategy, that is, the best strategy, not knowing what the other felon will do, is to
confess. Thus, the rational strategy leads to a worse outcome than cooperation would have.
Another example of suboptimal results due to lack of cooperation is called the tragedy of
the commons. A community of fishermen lives off a fertile strip of (common) fishing grounds.
A fisherman™s daily catch depends on investment in equipment. The aggregate investment de-
termines whether the fishing grounds will be depleted over time. If each fisherman maximizes
the net present value (NPV) of investment, they will deplete the grounds in a hurry. No fisher-
man takes into account the fact that his take reduces the stock of fish available to other fisher-
men. As a result, the grounds are over-fished. It is the common “ownership” of fishing
grounds that induces a prisoner™s dilemma. The declining state of the world™s fishing grounds
is testimony to the force of this dynamic.
It turns out, however, that under a variety of conditions, individuals do cooperate and will
defy predictions of economic theory. A manifestation of such behavior is shown in various
forms of the ultimatum game. Here, individual A is given $100 to divide with another indi-
vidual B. A makes an offer to B, say $10. B has a choice of taking the offer, in which case A
takes home $90 and B, $10. If B refuses the offer, both players get nothing. Conventional ra-
tional behavior would induce B to accept any offer, since the alternative is zero. Knowing this,
A™s rational offer is very small. But experiments clearly show that many deviate from this ra-
tional dictum. You can explain this either by A™s anticipation that B will be insulted and hence
reject a small offer, or by an altruistic motive of A to induce a reasonably fair allocation. The
degree to which people deviate from rational behavior varies greatly and is materially affected
by circumstances. But the fact remains that investor decision making is often perturbed by
various motives extraneous to conventional rationality.
Bodie’Kane’Marcus: VI. Active Investment 19. Behavioral Finance and © The McGraw’Hill
Essentials of Investments, Management Technical Analysis Companies, 2003
Fifth Edition




653
19 Behavioral Finance and Technical Analysis


Bidding and the Winner™s Curse
How much should you bid on an auctioned item whose value, you believe, is equally likely to
be anywhere in the range of $6 to $10? Should your bid depend on who else is bidding? Intu-
ition calls for bidding the expected value of $8, regardless of how many participate in the auc-
tion. The logic of this solution, however, misses this important question: What is the value of
the item, conditional on your winning the bid? Assuming all participants bid their expected

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