Presentation on theme: "CHAPTER 8 Behavioral Finance and the Psychology of Investing"— Presentation transcript:
1 CHAPTER 8 Behavioral Finance and the Psychology of Investing Chapter Sections:Introduction to Behavioral FinanceProspect TheoryOverconfidenceMisperceiving Randomness and Overreacting to Chance EventsSentiment-Based Risks and Limits to ArbitrageTechnical Analysis“The investor’s chief problem, and even his worst enemy, is likely to be himself.” Benjamin Graham
2 Investor Psychology Investor what?! Psycho-logy: The study of psycho’s?I prefer to call it Sly-chologyIn 1962, there was a brief recession and a sharp market downturn, the President’s chief economic adviser was giving a presentation to many of the political and economic leaders of the time, describing what they were doing to right the economy. One of the attendees asked, “So when is the stock market going to recover?” The adviser curtly responded, “I am an economist, Sir, not a psychiatrist.”
3 Investor Psychology(continued)Because of the tremendous amount of money involved in the markets,Much research has gone into trying to understand investor psychologySome of the research is very revealing about who and what we areNot only as investors but also as a species in general“There are three factors that influence the markets: Fear, Greed, and Greed.” – Old Wall Street saying
4 Common Investor Weaknesses Reading too much into the recent pastBeware the “Permanent Trend”Even though there are countless examples of investors “getting on the bandwagon” just as the wagon was about to veer into a ravine,We trick ourselves into believing that,“It’s Different This Time”“It’s a New Era”So did you pile into Apple or gold in 2011 and 2012?Did you buy oil in mid-2008?How did that condo conversion “flipper” in early-2006 work out?How about eToys, TheGlobe.com, or CMGI in 1999?
5 Common Investor Weaknesses (continued)Misperceiving randomnessEven though stock price movements in the short term are random, our brains will trick us into seeing a patternWe humans are “heuristic” – we look for patternsEven if we know that there aren’t any to be foundIn a series of a million random digits, the probability that one digit will be repeated 13 times in a row is essentially 100%In my humble opinion, Technical Analysts are guilty of this failing. We will discuss Technical Analysis soon.
6 Common Investor Weaknesses (continued)Being overconfidentBelieving you know more that you think you know, orBelieving you are better than most other investorsThe truth is we only see the “tip of the iceberg” with regard to what is happening within a company, an industry, and the economyAnd we are usually only average or mediocre investors at bestEspecially if we decide to become traders!Are you an excellent, good, average, fair, or poor driver?The “Lake Woebegone” Effect.
7 Common Investor Weaknesses (continued)Selling your winners too soon and hanging on to your losers (a.k.a. loss aversion)As humans, we hate to admit we made a mistake, so we stubbornly hold onto our losers, hoping that they will at least get back to where we bought inThe reality is that our memories are wired to forget unpleasant experiencesSell our losers and we will quickly forget about themHang onto them and we will always be reminded of our stupidityIn contrast, hanging onto the winners is what makes an investor rich. So hang onto your winners!
8 Fundamental Analysis Fundamental Analysis – (review) The in-depth study of the financial condition and operating results of a firmA method of evaluating securities by attempting to measure the intrinsic value of a particular stock. Fundamental analysts study everything from the overall economy and industry conditions, to the financial condition and management of companiesSimply put, the value of a stock is influenced by the performance of the company that issued the stock.The valuation models from Chapter 6 that we covered have all used fundamental analysis.
9 Fundamental Analysis Some of the Fundamentals – (review) (continued)Some of the Fundamentals – (review)The competitive position of the companyDo not forget to research their competitors!Its composition and growth in sales and earningsProfit margins and the dynamics of company earningsThe composition and liquidity of corporate resourcesWhat assets are availableThe company’s capital structureHow much debt, how much equitya.k.a. the “capitalization” of a companyBut there are many investors who don’t follow the Fundamentals.
10 Technical Analysis Technical Analysis The study of the various forces at work in the marketplace and their effect on stock pricesThose who adhere to technical analysis believe that they can predict the future price of a stock by analyzing the behavior of the stock price’s history and/or the overall stock marketOr any one or many of dozens of so-called “Technical Indicators”Simply put, the future price of a stock is influenced by factors other than the company’s fundamental future outlook.
11 Technical Analysis Argument in favor of Technical Analysis: Rebuttal: (continued)Argument in favor of Technical Analysis:Stock prices do tend to move in tandem to the stock market as a wholeWhen the market is rising, most stocks rise with it“A rising tide lifts all boats”When the market is falling, most stocks are brought down with itRebuttal:But that is just supply and demand at workWhen stocks are in favor, prices riseWhen stocks become out of favor, prices fallRepeat after me: “There has never been a reliable methodology for predicting the short-term behavior of the stock market.”
12 Tools of Technical Analysis Market PricesMomentum buying“The Trend is Your Friend”Support level versus Resistance levelSupport level – price or level below which a stock or the market as a whole is unlikely to fallResistance level – price or level above which a stock or the market as a whole is unlikely to risePsychological barriersDow 16,000, S&P 1,800, $100 for a stock, etc.Moving averageAn average price or index level, calculated using a fixed number of previous days’ prices or levels50-day, 200-day, etc. moving averageExamples:His top 10 trading rules are at 1609.cfm
13 Tools of Technical Analysis (continued)A technical trader follows the 50-day & 200-day moving averagesIf the 50-day crosses the 200-day from above, it is a bearish signalIf the 50-day crosses the 200-day from below, it is a bullish signal
14 Tools of Technical Analysis (continued)The Dow TheoryOne of the more historically popular price movement technical theoriesUses both the Dow Jones Industrial Average (a.k.a. the Dow) and the Dow Jones Transports AverageThe Dow theory tries to identify three forces:a primary direction or trend,a secondary reaction or trend, anddaily fluctuationsBy watching the changes in the primary and secondary directions of the indexes, you are supposed to be able to determine the overall direction of the market
15 Tools of Technical Analysis (continued)The primary direction is either bullish or bearish, and reflects the long-run direction of the market.Secondary trends, temporary departuresCorrections, reversions to the primary direction
16 Tools of Technical Analysis (continued)Relative StrengthMeasure of the performance of one investment relative to another or to the market as a wholeRecall The Value Line’s Relative Strength indicatorMarket VolumeHeavy volume versus low volumeHeavy volume with prices rising is (supposed to be) goodLow volume with prices falling is (supposed to be) goodHeavy volume with prices falling is (supposed to be) badLow volume with prices rising is (supposed to be) bad
17 Tools of Technical Analysis (continued)Breadth of the MarketThe Advance/Decline RatioHow many stocks went up, how many went downWhen the mood of investors is bullish, the advance/decline ratio should riseAdvancing issues will outnumber declining issuesWhen the mood of investors is bearish, the advance/decline ratio should fallDeclining issues will outnumber advancing issuesThe “Tick”The trade-by-trade direction of the marketUp Tick, Down TickOpening Tick, Closing TickBullish Tick, Bearish Tick
18 Tools of Technical Analysis (continued)Short InterestThe number of stocks sold short in the market at any given timeThe more stocks are sold short, the more investors believe the market will fallFor some reason, short investors are somehow considered more “sophisticated” and are therefore supposed to know when the market will fallBut when large numbers of investors sell short, eventually they must buy the shares backThis creates a pent up demand for stocksA large amount of short interest is like a compressed spring. Eventually, there will be a “short squeeze” and prices will rise.
19 Tools of Technical Analysis (continued)Odd-lot TradingTheory based on the idea that small investors tend to buy and sell in odd lotsRecall: An odd lot is less than 100 shares“The best thing to do is the opposite of what small investors are doing”If old-lot trading rises, it supposedly means that more and more small investors are entering the marketSmall investors are supposedly notorious for getting into the market at the top of a bull marketThe research and data behind this theory are very suspect. Plus technology has made odd-lot trading commonplace.
20 Tools of Technical Analysis (continued)Contrarian OpinionThe theory that if people are very optimistic, that is a predictor of falling prices for the market, and…If people are very pessimistic, that is a predictor of rising pricesTherefore, we all should be as bearish as possible and that will make the market rise, right?!We covered Contrarian Strategy already in Investment StrategiesBuy when others are sellingSell when others are buyingThe problem is the market historically has gone up three times more than it goes down
21 Tools of Technical Analysis (continued)ChartingThe activity of charting price behavior and other market information and then using the patterns these charts form to make investment decisionsHi-lo-close charts & candlestick chartsBar charts adapted to stocks and other investmentsChart formationsResistance and support levels – Breakout!Head and shouldersTrianglesFlag and pennantCup and saucer
27 You, Too, Can Be a Technical Analyst! “The market’s rise after a period of reaccumulation is a bullish sign. Nevertheless, fulcrum characteristics are not yet clearly present and a resistance area exists 40 points higher in the Dow, so it is clearly premature to say the next leg of the bull market is up. If, in the coming weeks, a test of the lows holds and the market breaks out of its flag, a further rise would be indicated. Should the lows be violated, a continuation of the intermediate term downward trend is called for. In view of the current situation, it is a distinct possibility that traders will sit in the wings awaiting a clearer delineation of the trend and the market will move in a narrow trading range.”I think it means,“If the market does not go up or down, it will remain unchanged.”Translation?A Random Walk Down Wall Street
28 Careers in Stocks Registered Representative a.k.a. Stockbroker, Financial Representative, Account Executive, Financial PlannerBackground checkNo shenanigans with other peoples’ moneyMust take Series 7 and Series 66Series 7 is difficult, 6 hours, 2 months of studyingSeries 66 is much easier, 2 to 4 weeks studyMust be sponsored by a brokerage firmSome brokerages exist simply to sponsor peopleExpect to pay a fee to them for the privilege of being sponsoredMany brokerages now sponsoring new recruits!
29 CHAPTER 8 – REVIEW Behavioral Finance and the Psychology of Investing Chapter Sections:Introduction to Behavioral FinanceProspect TheoryOverconfidenceMisperceiving Randomness and Overreacting to Chance EventsSentiment-Based Risks and Limits to ArbitrageTechnical AnalysisNext week: Chapter 9, Bonds – a.k.a. Fixed-Income Investments