Chapter 9 Behavioral Finance and Technical Analysis Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin.

Chapter 9

Behavioral Finance and

Technical Analysis

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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9.1 The Behavioral Critique

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Behavioralism bias

• MotivationStock prices in the 1990s did not appear to match “fundamentals,” e.g., high price earnings ratios

Evidence of refusal to sell losers

Economics discipline is exploring behavioral aspects of decision making

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Behavioralism

• Extrapolation bias

• Overconfidence

• Analysts tend to excessively extrapolate historical trends when forecasting.

• May lead to unsustainably high P/E ratios.

Some people exhibit overconfidence in their ability to pick stocks or have an exaggerated belief that ‘risk’ will hurt the other person but not them. As a result, they bid stock prices too high.

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Behavioralism

• Anchoring Bias & earnings

Many people become anchored to their ideas and will not update their expectations when new information arrives.

This underreaction to news leads to momentum in stock returns.

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Behavioralism

• Framing errors– Mental accounting

When cash is needed investors may spend dividends, but refuse to sell a small portion of stock to raise the money.

This may lead to a preference for stocks that pay larger dividends, even though tax liability may be greater.

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Behavioralism

• Framing errors– Regret Avoidance

• Regret from losses is greater than joy from gains.

• Regret is reduced with ‘shared pain.’

In order to induce investors to buy out of favor stocks, stocks with poor recent performance for example (value stocks), these stocks have to pay a higher expected return.

9-8

Behavioralism & Prospect TheoryStandard utility (satisfaction) theory versus prospect theory

• Standard utility theory of investments:

– Investors desire more wealth and less risk

– Wealth provides diminishing marginal utility, thus a gain of $1,000 provides less utility than the utility loss from losing $1,000.

• This gives rise to risk aversion.

• Prospect theory:

An alternative behavioral theory suggesting that investor utility depends on the change in wealth from the start of the investment rather than on the starting level of wealth.

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Prospect Theory Illustrated

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Why not arbitrage mispriced stocks?

• If some investors are letting behavioral biases affect prices, why don’t other better trained investors engage in profitable arbitrage?

• Part of reason for growth in hedge funds.

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Limits to arbitrage

• Fundamental Risk

• Short sale constraints

• Model Risk

Changes in fundamentals can wipe out any arbitrage profits, making the strategy risky.

Short sale constraints make it difficult to arbitrage overpriced securities.

How do you know when a security is truly mispriced? Your model may be giving you wrong signals.

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Figure 9.2 Pricing of Royal Dutch Relative to Shell (Deviation from Parity)

60:40 split of profits from merger between RD and Shell

Stock price ratio RD/Shell should = 60/40 = 1.5

If RD/Shell > 1.5 then short RD and buy Shell

If you had done this in 1993, you would have LOST money until 1999.

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Critiquing the Behavioral Critique•

•

•

–

It provides ______ that fit _________________ but there is no ______________ put forth and _____________________________.

Much of the empirical support for the behavioralist ideas in investments comes from _______________ ___________________.

Behavioralism has less to say about ____________ _________ and more to do with __________________

The behavioral literature is ___________ ___________________________________.

stories individual situationscoherent theory

some behaviors contradict others

one specific time period, the late 1990s

informationalefficiency allocational efficiency

very weak atproviding solutions to these problems

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9.2 Technical Analysis and Behavioral Finance

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Technical Trading Rules

1. Conceptual basis– All technical analysis (TA) assumes that there are

recurring and predictable patterns in stock prices which can be exploited to earn abnormal returns.

– Technical analysts believe:• Market prices conform to new data only slowly,

giving rise to price trends• Prices are affected by predictable behavioral or

psychological factors

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Point & Figure Charts

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Point & Figure Charts

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Point & Figure Charts

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Basic Types of Technical Analysis

2. Identifying trends using moving averages

50 period simple moving average (SMA) for INTEL superimposed on INTEL prices.

Crossing the SMA from above is a bear signal.

SMA Line

Insert Figure 9.7 here, move it to the back, line up the SMA arrow with the smooth line in the graph

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Figure 9.8 Level of the DJIA and the 5-Week Moving Average

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Basic Types of Technical Analysis

3. Dow Theory

• Three types of trends, only two are important

• Every stock has price peaks and troughs but if a series of peaks and troughs are rising it is a buy signal especially if volume is heavier during the peaks than the troughs

“Tertiary”

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Basic Types of Technical Analysis4. Relative Strength

A simple relative strength ratio could be constructed as ___________.

Increases in the relative strength ratio indicate the stock is outperforming the index and could indicate a buy or bullish signal.

ΔPi / ΔIndex

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Basic Types of Technical Analysis5. Breadth

– Breadth is the extent to which movements in a broad index are reflected widely in movements of individual stocks

– Measured as the difference between the number of advancing and declining stocks

– Also used in industry indexes

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Cumulative Breadth

• Cumulative breadth is found by adding the current day’s net advances or declines to the previous day’s total.

• The purpose is to gauge the trend.

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Basic Types of Technical Analysis6. Odd Lot index

Odd Lot traders are mostly individual investors that are relatively uninformed.

Contrarian philosophy … Do the opposite of the majority of the odd lot traders.

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TA Sentiment Indicators8. Short Interest

• Total number of shares of stock currently sold short

• High short interest may indicate that a stock’s price is expected to fall.

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TA Sentiment Indicators8. Trin Statistic

Volume declining/Number decliningTrin =

Volume advancing/Number advancing

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TA Sentiment Indicators• Confidence index

– Ratio of the average yield on 10 top-rated corporate bonds divided by the average yield on 10 intermediate-grade corporate bonds

• Put/call ratio– Call options give investors the right to buy at

a fixed exercise price and a put is the right to sell at a fixed exercise price

– Change in ratio can be given a bullish or bearish interpretation

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A Warning About Identifying Trends

• Difficulty in identifying common price patterns

One of these patterns is real and one of these is computer simulated with random price changes. Can you tell which is which?

Point? • Less than meets the eye• Data mining

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Figure 9.11 Actual and Simulated Changes in Weekly Stock Prices for 52 Weeks

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Selected Problems

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Problem 1

– The prices of growth stocks may be consistently bid too high due to investor overconfidence.

– Investors/analysts may extrapolate recent earnings (and dividend) growth too far into the future and thereby inflate stock prices, forcing poor returns eventually on growth portfolios.

– At any given time, historically high growth firms may revert to lower growth and value stocks may revert to higher growth, changing return patterns, this may happen over an extended time horizon.

a.

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Problem 1

Enough investors should prefer value stocks to growth stocks and bid up the prices of value stocks and drive down the prices of growth stocks until the “extra” return on the value stocks was eliminated.

b.

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Problem 2

a. Regret avoidance is indicated by his desire to sell when price rises to the cost basis. If this happens, it may indicate they may now be good performers and should be held.

o Fix: Look at expected return or terminal wealth not past losses.

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Problem 2

b. Extrapolation bias: Can lead to overconfidence about future performance of Country XYZ.

o Fix: Diversification benefits are greater if we spread the investments and we would want a forward looking forecast of international investments

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Problem 2

c. Mental accounting, mentally separating the speculative account from the retirement account.

o Fix: The investor should maximize the return per unit of risk for

the entire portfolio, not for arbitrary subsets where the client exhibits different levels of risk aversion.