Behavioral Finance and Technical Analysis
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McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Behavioral Finance and Technical Analysis
9Bodie, Kane, and MarcusEssentials of Investments, 9th Edition
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9.1 Behavioral Critique
• Behavioral Finance• Financial market model emphasizing potential implications of psychological factors affecting investor behavior
• Existence of irrational investors is not sufficient to render capital markets inefficient
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9.1 Behavioral Finance
• Information Processing• Forecasting errors
• People overvalue recent experience compared to prior belief when forecasting
• Overconfidence• People overestimate precision of beliefs or forecasts, and overestimate abilities
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9.1 Behavioral Finance
• Information Processing• Conservatism bias
• Investors too slow in updating beliefs in response to recent evidence
• Sample size neglect and representativeness• People prone to believe small sample is representative of population, infer patterns too quickly
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9.1 Behavioral Finance
• Behavioral Biases• Framing
• Decisions affected by how choices are posed, i.e. gains relative to low baseline level or losses relative to higher baseline
• Mental accounting• Form of framing; people segregate certain decisions
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9.1 Behavioral Finance
• Behavioral Biases• Regret avoidance
• People blame themselves for unconventional choices that turn out badly, avoid regret by making conventional decisions
• Prospect theory• Investor utility depends on gains/losses from starting position, rather than levels of wealth
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9.1 Behavioral Critique
• Limits to Arbitrage• Fundamental risk
• Market changes or irrationality can eliminate profits
• Implementation costs• Exploiting overpricing is difficult; costs and time limits can eliminate profits
• Model risk• Inaccurate models generate inaccurate stock values
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Figure 9.1A Conventional Utility Function
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Figure 9.1B Utility Function under Prospect Theory
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9.1 Behavioral Critique
• Limits to Arbitrage and Law of One Price• “Siamese twin” companies
• Dual-listed companies can appear to violate Law of One Price
• Equity carve-outs• Can violate Law of One Price due to inability to short sell
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9.1 Behavioral Critique
•
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Figure 9.2 Pricing of Royal Dutch Relative to Shell
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9.1 Behavioral Critique
• Bubbles and Behavioral Economics• Evidence of irrational investor behavior• Easier to identify once over
• Evaluating Behavioral Critique• No coherent theory• Most empirical support from one time period: late ‘90s
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9.2 Technical Analysis and Behavioral Finance
• Trends and Corrections• Moving average
• Average price over given interval, interval updated over time
• Attempts to identify underlying price directions
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Figure 9.3 Share Price, 50-Day Moving Average for Intel
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Figure 9.4 Moving Averages
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Table 9.1 Stock Price History
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9.2 Technical Analysis and Behavioral Finance
• Trends and Corrections• Point and figure charts
• Traces significant upward/downward movements in prices without regard to timing
• X denotes price increase, O denotes decrease• Sell/Buy signals generated when stock penetrates previous lows/highs
• Congestion area: Horizontal band of Xs/Os created by price reversals
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Figure 9.5 Point and Figure Chart for Table 9.1
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Figure 9.6 Point and Figure Chart for Atlantic Richfield
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9.2 Technical Analysis and Behavioral Finance
• Trends and Corrections• 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
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Figure 9.7 Market Diary
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Table 9.2 Breadth
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9.2 Technical Analysis and Behavioral Finance
• 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 intermediate-grade bond yield
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9.2 Technical Analysis and Behavioral Finance
• Sentiment Indicators• Short interest
• Total number of shares currently short-sold in market
• Put/call ratio• Ratio of put options to call options outstanding on stock
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9.2 Technical Analysis and Behavioral Finance
• A Warning• People perceive patterns where none exist• Data mining generates apparent patterns within limited data sets
• When evaluating rules, ask whether rule would be reasonable before looking at data
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Figure 9.8A Actual Stock Price Levels, 52 Weeks
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Figure 9.8B Simulated Stock Price Levels, 52 Weeks
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Figure 9.9A Actual Weekly Stock Price Changes, 52 Weeks
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Figure 9.9B Simulated Weekly Stock Price Changes, 52 Weeks