1. CHAPTER 8 Behavioral Finance and the Psychology of Investing
Chapter Sections:
Introduction to Behavioral Finance
Prospect Theory
Overconfidence
Misperceiving Randomness and Overreacting to Chance Events
Sentiment-Based Risks and Limits to Arbitrage
Technical 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-chology
In 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 psychology
Some of the research is very revealing about who and what we are
Not 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 past
Beware 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 randomness
Even though stock price movements in the short term are random, our brains will trick us into seeing a pattern
We humans are “heuristic” – we look for patterns
Even if we know that there aren’t any to be found
In 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 overconfident
Believing you know more that you think you know, or
Believing you are better than most other investors
The truth is we only see the “tip of the iceberg” with regard to what is happening within a company, an industry, and the economy
And we are usually only average or mediocre investors at best
Especially 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 in
The reality is that our memories are wired to forget unpleasant experiences
Sell our losers and we will quickly forget about them
Hang onto them and we will always be reminded of our stupidity
In 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 firm
A 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 companies
Simply 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 company
Do not forget to research their competitors!
Its composition and growth in sales and earnings
Profit margins and the dynamics of company earnings
The composition and liquidity of corporate resources
What assets are available
The company’s capital structure
How much debt, how much equity
a.k.a. the “capitalization” of a company
But 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 prices
Those 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 market
Or 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 whole
When 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 it
Rebuttal:
But that is just supply and demand at work
When stocks are in favor, prices rise
When stocks become out of favor, prices fall
Repeat 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 Prices
Momentum buying
“The Trend is Your Friend”
Support level versus Resistance level
Support level – price or level below which a stock or the market as a whole is unlikely to fall
Resistance level – price or level above which a stock or the market as a whole is unlikely to rise
Psychological barriers
Dow 16,000, S&P 1,800, $100 for a stock, etc.
Moving average
An average price or index level, calculated using a fixed number of previous days’ prices or levels
50-day, 200-day, etc. moving average
Examples:
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 averages
If the 50-day crosses the 200-day from above, it is a bearish signal
If the 50-day crosses the 200-day from below, it is a bullish signal

14. Tools of Technical Analysis
(continued)
The Dow Theory
One of the more historically popular price movement technical theories
Uses both the Dow Jones Industrial Average (a.k.a. the Dow) and the Dow Jones Transports Average
The Dow theory tries to identify three forces:
a primary direction or trend,
a secondary reaction or trend, and
daily fluctuations
By 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 departures
Corrections, reversions to the primary direction

16. Tools of Technical Analysis
(continued)
Relative Strength
Measure of the performance of one investment relative to another or to the market as a whole
Recall The Value Line’s Relative Strength indicator
Market Volume
Heavy volume versus low volume
Heavy volume with prices rising is (supposed to be) good
Low volume with prices falling is (supposed to be) good
Heavy volume with prices falling is (supposed to be) bad
Low volume with prices rising is (supposed to be) bad

17. Tools of Technical Analysis
(continued)
Breadth of the Market
The Advance/Decline Ratio
How many stocks went up, how many went down
When the mood of investors is bullish, the advance/decline ratio should rise
Advancing issues will outnumber declining issues
When the mood of investors is bearish, the advance/decline ratio should fall
Declining issues will outnumber advancing issues
The “Tick”
The trade-by-trade direction of the market
Up Tick, Down Tick
Opening Tick, Closing Tick
Bullish Tick, Bearish Tick

18. Tools of Technical Analysis
(continued)
Short Interest
The number of stocks sold short in the market at any given time
The more stocks are sold short, the more investors believe the market will fall
For some reason, short investors are somehow considered more “sophisticated” and are therefore supposed to know when the market will fall
But when large numbers of investors sell short, eventually they must buy the shares back
This creates a pent up demand for stocks
A 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 Trading
Theory based on the idea that small investors tend to buy and sell in odd lots
Recall: 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 market
Small investors are supposedly notorious for getting into the market at the top of a bull market
The research and data behind this theory are very suspect. Plus technology has made odd-lot trading commonplace.

20. Tools of Technical Analysis
(continued)
Contrarian Opinion
The 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 prices
Therefore, we all should be as bearish as possible and that will make the market rise, right?!
We covered Contrarian Strategy already in Investment Strategies
Buy when others are selling
Sell when others are buying
The problem is the market historically has gone up three times more than it goes down

21. Tools of Technical Analysis
(continued)
Charting
The activity of charting price behavior and other market information and then using the patterns these charts form to make investment decisions
Hi-lo-close charts & candlestick charts
Bar charts adapted to stocks and other investments
Chart formations
Resistance and support levels – Breakout!
Head and shoulders
Triangles
Flag and pennant
Cup and saucer

22. Charting Examples
Open-High-Low-Close Chart

23. Charting Examples
Candlestick
Chart

24. Charting Examples
Candlestick
Chart Formations

25. Charting Examples
Head-and-Shoulders
Chart

26. Charting Examples
Assorted
Charts
Good Luck!

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 Planner
Background check
No shenanigans with other peoples’ money
Must take Series 7 and Series 66
Series 7 is difficult, 6 hours, 2 months of studying
Series 66 is much easier, 2 to 4 weeks study
Must be sponsored by a brokerage firm
Some brokerages exist simply to sponsor people
Expect to pay a fee to them for the privilege of being sponsored
Many brokerages now sponsoring new recruits!

29. CHAPTER 8 – REVIEW Behavioral Finance and the Psychology of Investing
Chapter Sections:
Introduction to Behavioral Finance
Prospect Theory
Overconfidence
Misperceiving Randomness and Overreacting to Chance Events
Sentiment-Based Risks and Limits to Arbitrage
Technical Analysis
Next week: Chapter 9, Bonds – a.k.a. Fixed-Income Investments