1. McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Behavioral Finance and Technical Analysis Chapter 9

2. 9-2 Behavioral Finance Argues that rational financial theories ignore how people actually make decisions Behavioral Finance: emphasizes the potential implications of psychological factors  Anomalies result from irrationalities Criticism of Behavioral Finance  Existence of irrational investors is not sufficient to render capital markets inefficient  Rational investors should be able to correct prices

3. 9-3 Where are the Arbitragers? If arbitragers can exploit these behavioral mispricing then biases shouldn’t matter However, the ability to arbitrage maybe limited in the market:  Model risk: You are betting that you have a better estimate than the entire market BIG RISK  Fundamental risk: Mkt may take longer to correct mispricing than the investor can wait Keynes “Markets can remain irrational longer than you can remain solvent”

4. 9-4 Arbitrage Limits: Example 1 “Siamese twin” companies  Royal Dutch and Shell merged in 1907 One company with two shares: Royal (60% of profits) Shell (40% of profits) →Since Royal get 1.5 times the cash as Shell, Royal should sell for 1.5 times Shell Royal sold for less than Shell Equity carve-outs  3Com split off 5% of Palm, with 3Com shareholders get 1.5 shares of Palm 3Com share price fell below 1.5 of Palm

5. 9-5 Arbitrage Limits: Example 2 Equity carve-outs  3Com split off 5% of Palm, 3Com shareholders receive 1.5 shares of Palm →3Com shares should be worth 1.5 the price of Palm plus the value of 3Com  3Com share price fell below 1.5 of Palm

6. 9-6 People Have Issues Forecasting errors  People overvalue recent experience when forecasting Compared to prior belief Conservatism bias  People are reluctant to change there beliefs when things change Overconfidence  People overestimate their ability, or the accuracy of their predictions

7. 9-7 People Have More Issues Representativeness  People assume that most people think/feel the same way they do Everyone is like me Sample size neglect  Believe small sample is representative of population Infer patterns too quickly

8. 9-8 Behavioral Biases Framing  Decisions affected by how opportunities are posed A 30% chance to win v a 70% chance to loss Mental accounting  Form of framing; people segregate certain decisions, or accounts 1 risky account for vacation saving & 1 safe for college Disposition effect  People hold losses and sell winner

9. 9-9 Behavioral Biases: Continued Regret avoidance  People blame themselves more for unconventional decision than conventional decision No one gets fired for buying IBM Loss Aversion (Prospect theory)  People view gains and losses differently $1,000 loss has a large emotional impact than a $1,000 gain Fear of Regret  Avoiding new information

10. 9-10 Examples of “Irrational Exuberance” Japanese Real Estate Bubble 1986-1991  1 square mile was worth all of California Dot Com Bubble 1997-2000  Went from basing valuation on earnings (or profits) to view and clicks Housing Bubble 2006-2010  Everyone gets a loan

11. 9-11 Technical Analysts Irrationality and behavioral biases can move prices away from fundamentals This can potentially lead to exploitable recurring patterns in the market Technical Analysts are generally looking for momentum

12. 9-12 Detecting Momentum Moving Average: Average price over a given interval, interval updated over time Attempts to identify underlying price directions  Looking for trends Most general momentum signal:  Moving over you 52 week average is a bullish signal

13. 9-13 50-Day Moving Average for Intel Bullish Bearish

14. 9-14 3 Day Moving Average Example Day12345678 Price1012141615131211 Ave

15. 9-15 3 Day Moving Average Example Day12345678 Price1012141615131211 Ave

16. 9-16 More Chartist Terminology Breadth  Extent to which broad market index movements affect individual stock prices Relative Strength  Recent performance of given stock/industry compared to that of broad market index

17. 9-17 Sentiment Indicators Trin statistic  Ratio of average volume in declining issues to average volume in advancing issues Confidence index  Ratio of top-rated corporate bond yield to intermediate- grade bond yield Short interest  Total number of shares currently short-sold in market Put/call ratio  Ratio of put options to call options outstanding on stock

18. 9-18 A Warning about Technical Analysis People perceive patterns where none exist  Constellations Data mining generates apparent patterns within limited data sets When evaluating rules, ask whether rule would be reasonable before looking at data