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Behavioral Finance and Technical Analysis

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1 Behavioral Finance and Technical Analysis
Chapter 9 Behavioral Finance and Technical Analysis A more in depth look at EMH and its implications. Idea: Securities are fairly priced and one cannot expect to consistently outperform the market.

2 Behavioralism bias Motivation
Stock 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 9-2

3 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. Book calls this 'conservatism' 9-3

4 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. 9-4

5 Behavioralism & Prospect Theory
Standard 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. 9-5

6 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. Hedging in details; will be in Excel exam 9-6

7 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. A lot of arbitrage is not pure arbitrage its risky arbitrage How do you know when a security is truly mispriced? Your model may be giving you wrong signals. 9-7

8 9.2Technical Analysis and Behavioral Finance

9 Technical Trading Rules
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 The so called ‘disposition effect’ may help explain the first TA belief. Under the disposition effect investors exhibit loss aversion so that they are reluctant to sell on bad news and price converges slowly to its new fundamental value. While some investors undoubtedly behave this way, this seems unlikely to be a true description of market prices. 9-9

10 Point & Figure Charts http://www. spreadsheetml
The single asterisks in Table 9.1 mark an event resulting in the placement of a new X or O in the chart. The daggers denote price movements that result in tie start of a new column of Xs or Os. 9-10

11 Basic Types of Technical Analysis
Identifying trends using moving averages Crossing the SMA from above is a bear signal; from below is a bull signal. 9-11

12 Basic Types of Technical Analysis
Dow Theory 3 Trends: Primary: Months or years, Intermediate, Daily to Weekly, maybe a month, Minor is mostly intraday and can be ignored. 9-12

13 Basic Types of Technical Analysis
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 9-13

14 Basic Types of Technical Analysis
Breadth Measured as the difference between the number of advancing and declining stocks Also used in industry indexes 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. 9-14

15 TA Sentiment Indicators
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. (Could be bullish on the covers later) 9-15

16 TA Sentiment Indicators
Trin Statistic 9-16

17 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 9-17

18 A Warning About Identifying Trends
Difficulty in identifying common price patterns Less than meets the eye Data mining One on the left is real, the one on the right is simulated. 9-18

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