Transcript 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.

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
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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.”
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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
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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 are you piling into gold and Treasury bonds now?
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?
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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.
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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. http://prairiehome.publicradio.org/
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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!
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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.
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Fundamental Analysis

(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.
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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.
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Technical Analysis

(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.”
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Tools of Technical Analysis

Market Prices
Examples:
www.stockmarketmentor.com/public/607.cfm
www.stockmarketmentor.com/public/2335.cfm
His top 10 trading rules are at 1609.cfm
 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 13,000, S&P 1,500, $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
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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
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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
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Tools of Technical Analysis
(continued)
Dow Jones Industrial Average,
January 2, 2001 to October 3, 2003
12,000
The primary direction is either bullish or bearish, and
reflects the long-run direction of the market.
11,000
Level
10,000
9,000
Secondary
trends,
temporary
departures
8,000
Corrections,
reversions to the
primary direction
7,000
01/01
04/01
07/01
10/01
01/02
04/02
07/02
Date
10/02
01/03
04/03
07/03
10/03
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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
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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
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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.
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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.
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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
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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
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Charting Examples
Open-High-LowClose Chart
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Charting Examples
Candlestick
Chart
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Charting Examples
Candlestick
Chart Formations
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Charting Examples
Head-and-Shoulders
Chart
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Charting Examples
Assorted
Charts
Good Luck!
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,
does not go up or down,
Translation? “If the market
it will remain unchanged.”
A Random Walk Down Wall Street
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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!
CHAPTER 8 – REVIEW
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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