1. Behavioral Finance and Technical Analysis
Chapter 9
Behavioral Finance and Technical Analysis
Describes the financial instruments traded in primary and secondary markets.
Discusses Market indexes. Discusses options and futures.
McGraw-Hill/Irwin
Copyright © by The McGraw-Hill Companies, Inc. All rights reserved. 1

2. 9.1 The Behavioral Critique

3. 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

4. Behavioralism Extrapolation bias Overconfidence
Analysts tend to excessively extrapolate historical trends when forecasting.
May lead to unsustainably high P/E ratios.
Overconfidence is experience based. Note extrapolation bias is a form of overconfidence.
Some people exhibit overconfidence in their ability to pick stocks or have an exaggerated belief that ‘risk’ will hurt the other person but not them. As a result, they bid stock prices too high.

5. 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'

6. Behavioralism Framing errors Mental accounting
When cash is needed investors may spend dividends, but refuse to sell a small portion of stock to raise the money.
This may lead to a preference for stocks that pay larger dividends, even though tax liability may be greater.
Lots of other examples possible here.

7. 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.

8. 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. Prospect Theory Illustrated
Prospect theory is an example of loss aversion. To the left of zero in Panel B an investor is in the domain of losses and becomes risk seeking. In other words, if you think you are going to take a loss, you are more likely to take a risk in hopes of avoiding the loss, even if it is not a good gamble. I have conducted a test in class that demonstrates people do exhibit loss aversion.

10. 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.

11. 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.

12. Figure 9.2 Pricing of Royal Dutch Relative to Shell (Deviation from Parity)
In 1907 Royal Dutch Petroleum merged with Shell Transport, although their stock continued to trade separately. Under the merger agreement RD receives 60% of the profits of the joint company and ST receives 40%. Hence the ratio of the share price of RD/ST should be 60/40 or The price has deviated from this parity level for extended periods of time.
You can find similar evidence in equity carve outs and perhaps in closed end fund discounts and premiums, although both of these may have other explanations.
Remember Keynes’ quote, “Markets can remain irrational longer than you can remain solvent.” What if prices don’t conform to your models in the near term? This can be disastrous if you are levered. Ultimately this is why Long Term Capital Management Hedge Fund failed. In the long run their bets were correct, but the markets did not return to ‘normal’ levels immediately and the fund’s huge amount of leverage forced it under.
60:40 split of profits from merger between RD and Shell
Stock price ratio RD/Shell should = 60/40 = 1.5
If RD/Shell > 1.5 then short RD and buy Shell
If you had done this in 1993, you would have LOST money until 1999.

13. Critiquing the Behavioral Critique
It provides ______ that fit _________________ but there is no ______________ put forth and _____________________________.
stories
individual situations
coherent theory
some behaviors contradict others
Much of the empirical support for the behavioralist ideas in investments comes from _______________ ___________________.
one specific time
period, the late 1990s
Behavioralism has less to say about ____________ _________ and more to do with __________________
informational
efficiency
allocational efficiency
It seems to me that most of the behavioral problems stem from a lack of training in economics. Many of them derive from overreliance on historical or statistical data rather than understanding the underlying economics of a given investment. At a minimum being aware of these potential pitfalls in decision making should help investors avoid such errors.
very weak at
providing solutions to these problems
The behavioral literature is ___________ ___________________________________.

14. 9.2 Technical Analysis and Behavioral Finance

15. 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.

16. Point & Figure Charts
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.
Sell signals are generated when the stock price penetrates previous lows, and buy signals occur when previous high prices are penetrated A. levels and are indicated in Figure 9.6, which is an actual chart for Atlantic Richfield.

17. Point & Figure Charts
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.

18. Point & Figure Charts
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.

19. Basic Types of Technical Analysis
Identifying trends using moving averages
Insert Figure 9.7 here, move it to the back, line up the SMA arrow with the smooth line in the graph
SMA Line
50 period simple moving average (SMA) for INTEL superimposed on INTEL prices.
Crossing the SMA from above is a bear signal.

20. Figure 9.8 Level of the DJIA and the 5-Week Moving Average

21. Basic Types of Technical Analysis
Dow Theory
“Tertiary”
3 Trends: Primary: Months or years, Intermediate, Daily to Weekly, maybe a month, Minor is mostly intraday and can be ignored.
Three types of trends, only two are important
Every stock has price peaks and troughs but if a series of peaks and troughs are rising it is a buy signal especially if volume is heavier during the peaks than the troughs

22. 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

23. Basic Types of Technical Analysis
Breadth
Breadth is the extent to which movements in a broad index are reflected widely in movements of individual stocks
Measured as the difference between the number of advancing and declining stocks
Also used in industry indexes

24. Cumulative Breadth
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.

25. Basic Types of Technical Analysis
Odd Lot index
Odd Lot traders are mostly individual investors that are relatively uninformed.
Contrarian philosophy … Do the opposite of the majority of the odd lot traders.
This index can be found in the Wall Street Courier Online

26. 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)

27. TA Sentiment Indicators
Trin Statistic

28. 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

29. A Warning About Identifying Trends
Difficulty in identifying common price patterns
One on the left is real, the one on the right is simulated.
One of these patterns is real and one of these is computer simulated with random price changes. Can you tell which is which?
Point?
Less than meets the eye
Data mining

30. Figure 9.11 Actual and Simulated Changes in Weekly Stock Prices for 52 Weeks
One on the left is real, one on the right is simulated.

31. Selected Problems

32. Problem 1 a.
The prices of growth stocks may be consistently bid too high due to investor overconfidence.
Investors/analysts may extrapolate recent earnings (and dividend) growth too far into the future and thereby inflate stock prices, forcing poor returns eventually on growth portfolios.
At any given time, historically high growth firms may revert to lower growth and value stocks may revert to higher growth, changing return patterns, this may happen over an extended time horizon. 32

33. Problem 1
Enough investors should prefer value stocks to growth stocks and bid up the prices of value stocks and drive down the prices of growth stocks until the “extra” return on the value stocks was eliminated. b. 33

34. Problem 2
Regret avoidance is indicated by his desire to sell when price rises to the cost basis. If this happens, it may indicate they may now be good performers and should be held.
Fix:
Look at expected return or terminal wealth not past losses. 34

35. Problem 2
Extrapolation bias: Can lead to overconfidence about future performance of Country XYZ.
Fix:
Diversification benefits are greater if we spread the investments and we would want a forward looking forecast of international investments 35

36. Problem 2
Mental accounting, mentally separating the speculative account from the retirement account.
Fix:
The investor should maximize the return per unit of risk for
the entire portfolio, not for arbitrary subsets where the client exhibits different levels of risk aversion. 36