Behavioral Finance and Technical Analysis CHAPTER 19

Behavioral Finance Traditional theory ignores some aspects of personal behavior Behavioral finance tries to incorporate personal behavior to extend corporate finance Behavioral finance is a developing area

Individual Behavior Cooperation and Altruism Bidding and the Winner’s Curse Endowment Effect, Status Quo Bias and Loss Aversion Mental Accounts

Figure 19-1 Loss Aversion Preference Function

Asset Returns and Behavioral Explanations Calendar effects Cash dividends Overreaction and mean reversion

Explanations that Fail the Empirical Test Controversial explanations from behavioral finance Closed-end fund pricing Excess volatility in stock prices Loss Aversion and CBOT Traders

Charting Dow theory Point and figure charts Candlestick charts Actual versus simulated results

Figure 19-2 Dow Theory Trends

Figure 19-3 Dow Jones Industrial Averages in 1988

Figure 19-4 Point and Figure Chart for Table 19-2

Table 19-2 Stock Price History

Figure 19-5 Point and Figure Chart for Atlantic Richfield

Figure 19-6 Candlestick Chart

Figure 19-7 Actual and Simulated Stock Prices for 52 Weeks

Figure 19-8 Actual and Simulated Changes in Weekly Stock Prices for 52 Weeks

Sentiment Indicators Trin Statistics If Trin > 1.0 bearish signal # Advancing / # Declining Volume Advancing / Volume Declining # Declining / Volume Declining # Advancing / Volume Advancing If Trin > 1.0 bearish signal

Sentiment Indicators Put / Call Ratio Mutual Fund Cash Position Historical value 65% When higher than 65% a signal occurs Bearish view Bullish view Mutual Fund Cash Position Cash levels are low - bearish sign Cash levels are high - bullish sign

Sentiment Indicators Odd - Lot Trading Ratio of odd-lot purchases to odd-lot sales When ratio exceeds 1.0, bearish sign Contrarian logic - small investors are the last to buy in bull markets

Flow of Funds Indicators Short Interest - total number of shares that are sold short When short sales are high a signal occurs Bullish interpretation Bearish interpretation Credit Balances in Brokerage Accounts Investor leave balances when they plan to invest in the future When levels are high a bullish sign

Market Structure Indicators Moving Averages Average price over some historical period (5 weeks or 200 days) When current price crosses the average a trading signal occurs Bullish signal when the current price rises above the moving average Bearish sign when the current price falls below the moving average

Figure 19-10 Moving Average for Microsoft

Figure 19-11 Moving Averages

Market Structure Indicators Breadth The extent to which movements in a broad index are reflected widely in movements of individual stocks Spread between advancing stocks and declining stocks Also used in industry indexes

Table 19-4 Breadth

Figure 19-12 Cumulative Difference in Returns of Previously Best and Worst Ranking Stocks in Subsequent Months

Value Line System Widely followed with some evidence of superior performance Value Line System is predominately a technical system Earnings momentum Relative stock prices Ratios of moving averages

Figure 19-13 Record of Value Line Ranking for Timeliness (without adjustment for change in rankings) 1965-1990

Value Line System Paper vs actual performance indicates that the system is difficult to implement Value Line Fund has not shown superior performance High turnover costs are associated with the strategy Evidence shows prices react quickly to reported ranking changes