Transcript Document

Behavioral Finance and
Technical Analysis
Chapter 9
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
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
9-2
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”
9-3
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
9-4
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
9-5
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
9-6
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
9-7
Behavioral Biases

Framing
Decisions affected by how opportunities are
posed


Mental accounting
Form of framing; people segregate certain
decisions, or accounts


A 30% chance to win v a 70% chance to loss
1 risky account for vacation saving & 1 safe for college
Disposition effect
 People
hold losses and sell winner
9-8
Behavioral Biases: Continued

Regret avoidance
People blame themselves more for
unconventional decision than conventional
decision


Loss Aversion (Prospect theory)
People view gains and losses differently


No one gets fired for buying IBM
$1,000 loss has a large emotional impact than a $1,000
gain
Fear of Regret
 Avoiding
new information
9-9
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
9-10
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

9-11
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
9-12
50-Day Moving Average for Intel
Bearish
Bullish
9-13
3 Day Moving Average Example
Day
1
2
3
4
5
6
7
8
Price
10
12
14
16
15
13
12
11
Ave
9-14
3 Day Moving Average Example
Day
1
2
3
4
5
6
7
8
Price
10
12
14
16
15
13
12
11
Ave
9-15
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

9-16
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 intermediategrade bond yield

Short interest
 Total

number of shares currently short-sold in market
Put/call ratio
 Ratio
stock
of put options to call options outstanding on
9-17
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

9-18