Chapter 9
Behavioral
Finance and
Technical
Analysis
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 9
Behavioral Finance and
Technical Analysis
9-2
9.1 The Behavioral Critique
9-3
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
9-4
Behavioralism
• Extrapolation bias
– Analysts tend to excessively extrapolate historical
trends when forecasting.
– May lead to unsustainably high P/E ratios.
• 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.
9-5
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.
9-6
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.
9-7
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.
9-8
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.
9-9
Prospect Theory Illustrated
9-10
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.
• Must be limits to arbitrage!
9-11
Limits to arbitrage
• Fundamental Risk
Changes in fundamentals can wipe out any arbitrage
profits, making the strategy risky.
• Short sale constraints
Short sale constraints make it difficult to arbitrage
overpriced securities.
• Model Risk
How do you know when a security is truly mispriced?
Your model may be giving you wrong signals.
9-12
Figure 9.2 Pricing of Royal Dutch
Relative to Shell (Deviation from Parity)
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.
9-13
Critiquing the Behavioral Critique
It provides ______
stories that fit _________________
individual situations but
there is no ______________
coherent theory put forth and
_____________________________.
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 ____________
informational
efficiency and more to do with allocational
efficiency
_________
__________________
The behavioral literature is very
___________
weak at
___________________________________.
providing
solutions to these problems
9-14
9.2Technical Analysis and Behavioral
Finance
9-15
Technical Trading Rules
1. 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
9-16
Point & Figure Charts
9-17
Point & Figure Charts
9-18
Point & Figure Charts
9-19
Basic Types of Technical
Analysis
2. Identifying trends using moving averages
50 period simple moving average (SMA) for
INTEL superimposed on INTEL prices.
Crossing the SMA from above is a bear signal.
9-20
Figure 9.8 Level of the DJIA and the
5-Week Moving Average
9-21
Basic Types of Technical Analysis
3. Dow Theory
“Tertiary”
• 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
9-22
Basic Types of Technical Analysis
4. Relative Strength
• A simple relative strength ratio could be
constructed as ΔPi / ΔIndex
• Increases in the relative strength ratio
indicate the stock is outperforming the
index and could indicate a buy or bullish
signal.
9-23
Basic Types of Technical Analysis Breadth
•
•
•
Breath: the difference between the number of advancing and
declining stocks
Breadth is the extent to which movements in a broad index
are reflected widely in movements of individual stocks
Also used in industry indexes
9-24
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.
9-25
Basic Types of Technical Analysis
6. 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.
9-26
TA Sentiment Indicators
8. 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.
9-27
TA Sentiment Indicators
8. Trin Statistic
Volume declining/Number declining
Trin =
Volume advancing/Number advancing
9-28
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
9-29
A Warning About Identifying Trends
• Difficulty in identifying common price patterns
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
9-30
Figure 9.11 Actual and Simulated Changes
in Weekly Stock Prices for 52 Weeks
9-31
9.3 Selected Problems
9-32
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.
9-33
Problem 1
b. 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.
9-34
Problem 2
a. 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.
o Fix: Look at expected return or terminal wealth not past losses.
9-35
Problem 2
b. Extrapolation bias: Can lead to overconfidence about future
performance of Country XYZ.
o Fix: Diversification benefits are greater if we spread the investments
and we would want a forward looking forecast of international
investments
9-36
Problem 2
c. Mental accounting, mentally separating the speculative
account from the retirement account.
o 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.
9-37
Behavioral Finance for Everyday Investors: Herding
http://www.youtube.com/user/FranklinTempletonTV?v=TbO2RWYOitc