1. Overconfidence {health care discussion at JD s} 2. Biased Judgments. 3. Herding. 4. Loss Aversion

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1 In conditions of laissez-faire the avoidance of wide fluctuations in employment may, therefore, prove impossible without a far-reaching change in the psychology of investment markets such as there is no reason to expect. I conclude that the duty of ordering the current volume of investment cannot safely be left in private hands. (Keynes, GT, p. 320) 1. Overconfidence {health care discussion at JD s} 2. Biased Judgments 3. Herding 4. Loss Aversion

2 a. Shorting You are bearish on Telecom stock and decide to sell short 100 shares at the current market price of $50. a. How much in cash (or, securities) must you put into your brokerage account if the broker s initial margin requirement is 40%? In this case, you will instruct your broker to sell 100 shares that you don t have at a price of $50. Your broker will keep the proceeds of your sale in an account for you. The broker will require you to put an additional $2,000 (simply 40% of the sale) into the account. The broker has made you a loan of $5,000 think of it as the broker simply loaning you the $5,000 to purchase the shares for yourself, which you turn around and sell immediately and requires you to put up $2,000 just in case things go bad with this deal..40 = ($5,000 + $2,000) $5,000 $5,000 b. How high can the price of the stock go before you get a margin call if the maintenance margin is 30%? Note, I ve used a maintenance margin different from the initial margin just to add more realism to the situation the maintenance margin typically being less than the initial so that if the price does move a bit in the wrong direction, the broker need not bug you with small changes. Now, let s simplify the above equation a bit. Recall, the $5,000 is merely the price per share (P) times the number of shares (X) let the margin by (M) and your dollar invested by (C). + C M = = C Now, solve for P and put in the numbers from the question. P C = MX = $2,000 (.30)(100) = $2, = $66.67 Thus, if the price should rise above $66.67 per share, then you will receive a call from the broker requesting that you put more money into your account. c. What would be your rate of return if the stock price fell to $40 at the time you decided to liquidate your position? Considering that you sold at $50 per share and can now buy at the shares at $40 in order to repay the 100 shares to your broker you make a profit of $10 per share, or $1,000 total on an investment of $2,000. The rate of return is 50%. $5,000 $4,000 r = $2,000 =.50 = 50%

3 b. Margin buying You are bullish on Intel stock. The current market price is $50 per share and you have $5,000 of your own to invest. You borrow an additional $5,000 from your broker at an interest rate of 8% per year and invest $10,000 in the stock. a. What will be your rate of return if the price of Intel stock goes up by 10% during the next year? (ignore any dividend payments) The stock price will rise to $55 (=$50 x 1.10). So, the value of the stock rose from $10,000 to $11,000 (=$55 x 200). The fact that you borrowed $5,000 at 8% interest for a year means that you ll need to pay $400 in interest (=$5,000 x.08). Hence, you have made a profit of $600 ($1,000-$400) on the deal with an investment of $5,000 for a rate of return of 12%. $11,000 ($10,000 + $400) r = $5,000 =.12 = 12% b. What would your rate of return be if you had simply invested your own $5,000 in the stock assuming the stock price behaved as in part (a)? The value of the stock would have risen from $5,000 to $5,500 (=$5,000 x 1.10) for a profit of $500 on an investment of $5,000. $5,500 $5,000 r = =.10 = 10% $5,000 Notice, you get only a slightly higher rate of return from buying on margin in this example because the interest rate on the loan was high relative to the increase in the stock price. If we had ignored the interest rate on the loan, then your rate of return for part (a) would have been 20% - double the rate of return using your own money. c. How far does the price of the stock have to fall for you to get a margin call if the maintenance margin is 30%? Initially, we had a 50% margin. We state the maintenance margin in the following way: M C L = C $10,000 $5,000 = =.50 $10,000 Where M is the margin, C the collateral (in this case the broker is holding your stock in an account for you) and L the loan from your broker. The value of the collateral will change when the price per share changes. If we substitute for the value of the collateral (noting that in this example the number of shares, X, must have been 200), then we can solve for P.

4 L M = = 1 L = 1 M L P = (1 L M ) X $5,000 $5,000 = = = $35.71 (1.3) Thus, if the price falls to $35.71, then the value of your collateral will fall to $7,142.86, which translates to a margin of $7, $5,000 M = =.30 = 30% $7,142.86

5 1. Suppose as you walked into class today I handed you $30 in cash. Now, suppose I offered you the following choices (circle your answer): A. A flip of a coin where if Heads comes up you win $9, but if tail comes up you lose $9. B. No flip of the coin at all. 1*. Suppose I offered you the following choices (circle your answer): A. A flip of a coin where if Heads comes up you win $39, but if tail comes up you win $21. B. I simply give you $ Imagine a community preparing for the outbreak of a dreaded disease. The experts have predicted the disease will kill 600 people if nothing is done, but they offer two different programs to deal with the problem. Circle the program you would choose. A. Under this program 200 people will be saved. B. Under this program there is a one-third chance that all 600 people will be saved and a twothirds chance that everybody will die. 2*. Imagine a community preparing for the outbreak of a dreaded disease. The experts have predicted the disease will kill 600 people if nothing is done, but they offer two different programs to deal with the problem. Circle the program you would choose. A. Under this program 400 people will die. B. Under this program there is a one-third chance nobody will die and a two-thirds chance that 600 people will die. 3. Which of the following bets would you take? (circle all answers you can choose more than 1) A. Flip a coin, heads you win $100 and tails you lose $100. B. Flip a coin, heads you win $200 and tails you lose $100. C. Flip a coin, heads you win $300 and tails you lose $100. D. I would not take any of the above bets. However, I would take bet B if the bet was repeated 1,000 times. E. I would not take any of the above. 4. Suppose you were given the opportunity to enter one of the following two-stage contests. Circle the contest you would choose. A. In stage 1, you had a 75% chance of being told to go home and a 25% chance of being told to go on to the next stage. In stage 2, you would have an 80% chance to win $4,000. B. In stage 1, you had a 75% chance of being told to go home and a 25% chance of being told to go on to the next stage. In stage 2, you would be given $3000. [.25 x.80 =.20 and.20 x 4,000 = $800;.25 x 1.0 =.25 and.25 x 3,000 = 750] 9-14 points conservative investor points moderate investor points aggressive investor

6 1. Suppose as you walked into class today I handed you $30 in cash. Now, suppose I offered you the following choices (circle your answer): A. A flip of a coin where if Heads comes up you win $9, but if tail comes up you lose $9. B. No flip of the coin at all. 1*. Suppose I offered you the following choices (circle your answer): A. A flip of a coin where if Heads comes up you win $39, but if tail comes up you win $21. B. I simply give you $ Imagine a community preparing for the outbreak of a dreaded disease. The experts have predicted the disease will kill 600 people if nothing is done, but they offer two different programs to deal with the problem. Circle the program you would choose. A. Under this program 200 people will be saved. B. Under this program there is a one-third chance that all 600 people will be saved and a twothirds chance that everybody will die. 2*. Imagine a community preparing for the outbreak of a dreaded disease. The experts have predicted the disease will kill 600 people if nothing is done, but they offer two different programs to deal with the problem. Circle the program you would choose. A. Under this program 400 people will die. B. Under this program there is a one-third chance nobody will die and a two-thirds chance that 600 people will die. 3. Which of the following bets would you take? (circle all answers you can choose more than 1) A. Flip a coin, heads you win $100 and tails you lose $100. B. Flip a coin, heads you win $200 and tails you lose $100. C. Flip a coin, heads you win $300 and tails you lose $100. D. I would not take any of the above bets. However, I would take bet B if the bet was repeated 1,000 times. E. I would not take any of the above. 4. Suppose you were given the opportunity to enter one of the following two-stage contests. Circle the contest you would choose. A. In stage 1, you had a 75% chance of being told to go home and a 25% chance of being told to go on to the next stage. In stage 2, you would have an 80% chance to win $4,000. B. In stage 1, you had a 75% chance of being told to go home and a 25% chance of being told to go on to the next stage. In stage 2, you would be given $3000.

7 How do you view RISK? Circle your answer for each question. 1. Just 60 days after you put money into an investment, its price falls 20 percent. Assuming none of the fundamentals have changed (e.g., earnings potential, debt to equity ratios, etc.), what would you do? a. Sell to avoid further worry and try something else b. Do nothing and wait for the investment to come back. c. Buy more. It was a good investment before; now it s a cheap investment, too. For question 2-4, now look at the previous question another way. Your investment fell 20 percent, but it s part of a portfolio being used to meet investment goals with three different time horizons. 2. What would you do if the goal were five years away? a. Sell b. Do nothing c. Buy more 3. What would you do if the goal were 15 years away? a. Sell b. Do nothing c. Buy more 4. What would you do if the goal were 30 years away? a. Sell b. Do nothing c. Buy more 5. The price of your retirement investment jumps 25% a month after you buy it. Again, the fundamentals haven t changed. After you finish gloating, what do you do? a. Sell it and lock in your gains b. Stay put and hope for more gain c. Buy more: it could go higher 6. You re investing for retirement, which is 15 years away. Which would you rather do? a. Invest in a money-market fund or guaranteed investment contract, giving up the possibility of major gains, but virtually assuring the safety of your principal. b. Invest in a mix of bond funds and stock funds, in hopes of getting some growth, but also giving yourself some protection in the form of steady income. c. Invest in aggressive growth mutual funds whose value will probably fluctuate significantly during the year, but have the potential for impressive gains over five or 10 years.

8 7. You just won a big prize! But which one? It s up to you. a. $2,000 in cash b. A 50% chance to win $5,000 c. A 20% chance to win $15, A good investment opportunity just came along. But you have to borrow money to get in, would you take out a loan? a. Definitely not b. Perhaps c. Yes 9. Your company is selling stock to its employees. In three years, management plans to take the company public. Until then, you won t be able to sell your shares and you will get no dividends. But your investment could multiply as much as 10 times when the company goes public. How much money would you invest? a. None b. Two months salary c. Four months salary Scoring Your Rick Tolerance: To score the quiz, add up the number of answers you gave in each category a-c, and then multiply as shown to find your score (a) answers x1 = points (b) answers x2 = points (c) answers x3 = points YOUR SCORE points

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