Fin2802: Investments
Spring, 2010
Dragon Tang
Lectures 11&12
Behavioral Finance and Technical Analysis
February 23&25, 2010
Readings: Chapter 12
Practice Problem Sets: 1,2,4,10, 11
Fin 2802, Spring 10 - Tang
Chapter 12: Behavioral Finance and Technical Analysis
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Where Are We?
How?
Securities
Markets
Institutions
Trading
Delegated investment
Why?
Market efficiency
Historical performance
What?
Stock
Bond
Evaluation
International
Fin 2802, Spring 10 - Tang
Chapter 12: Behavioral Finance and Technical Analysis
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Where Are We?
How?
Securities
Markets
Institutions
Trading
Delegated investment
Why?
Market efficiency
Historical performance
What?
Stock
Bond
Evaluation
International
So What?
Fin 2802, Spring 10 - Tang
Chapter 12: Behavioral Finance and Technical Analysis
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Behavioral Finance and Technical Analysis
Objectives:
1. Understand the principles of behavioral finance.
2. Identify reasons why technical analysis may be profitable.
3. Use the Dow theory to identify situations that technicians
would characterize as buy or sell opportunities.
4. Use indicators such as volume, breadth, short interest, or
confidence indexes to measure the "technical condition" of
the market.
5. Explain why most of technical analysis is at odds with an
efficiently functioning stock market.
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Chapter 12: Behavioral Finance and Technical Analysis
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Behavioral Finance
• Traditional theories (e.g., CAPM) assume rational investors
• Systematic behavioral biases (anomalies) have been
observed
• Behavioral finance tries to incorporate some aspect of
investors’ behavior and explain those anomalies using
psychological principles
• It is a developing and important area
• Companies exploiting behavioral biases:
Lakonishok, Shleifer and Vishny (LSV)
Dimensional Fund Advisors (DFA)
Fuller and Thaler Asset Management
Case-Shiller-Weiss
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Chapter 12: Behavioral Finance and Technical Analysis
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Individual Behavior
• Cooperation and Altruism
• Bidding and the Winner’s Curse
• Endowment Effect, Status Quo Bias and Loss
Aversion
• Mental Accounts
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Chapter 12: Behavioral Finance and Technical Analysis
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Figure 12-1 Loss Aversion Preference Function
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Chapter 12: Behavioral Finance and Technical Analysis
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Asset Returns and Behavioral Explanations
• Calendar Effects
• Cash Dividends
• Overreaction and Mean Reversion
• Controversial explanations from behavioral finance
– Closed-end fund discount puzzle
– Excess volatility in stock prices
– Loss aversion
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Chapter 12: Behavioral Finance and Technical Analysis
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Limits to Arbitrage
• Fundamental Risk
• Implementation Costs
• Model Risk
• Siamese Twin Companies
• Equity Carve-outs
• Closed-End Funds
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Chapter 12: Behavioral Finance and Technical Analysis
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Figure 12.2 Pricing of Royal Dutch Relative to Shell (Deviation from Parity)
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Chapter 12: Behavioral Finance and Technical Analysis
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Technical Analysis
• Attempts to exploit stock price patterns for
profit.
• Assumes prices adjust slowly to their true
equilibrium values
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Chapter 12: Behavioral Finance and Technical Analysis
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Technical Analysis and EMH
• Technical analysis clashes with the EMH
hypothesis.
• EMH predicts rapid adjustment of prices
with the onset of new information.
• Evidence for the success of technical
analysis is poor.
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Chapter 12: Behavioral Finance and Technical Analysis
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Technical Analysis Tool-kit
• Charting: The analysis of “charts” of stock price
and volume with the hope of finding patterns to
exploit in the markets.
– The Dow Theory
– Point and Figure Chart
– Elliott Wave Theory
• Technical Indicators
– Sentiment Indicators: Market Volume (Trin Statistic); Oddlot Trading; Confidence Index; Put/Call Ratio; Mutual Fund
Cash Position
– Flow of Funds: Short Interest; Credit balances in brokerage
accounts
– Market Structure: Moving Averages; Breadth; Relative
Strength;
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Chapter 12: Behavioral Finance and Technical Analysis
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Charting: The Dow Theory
The Dow Theory:
•Uses price and volume trends to predict
stock prices.
•Identifies primary, secondary, and tertiary
trends.
•Predicts support and resistance price levels.
Fin 2802, Spring 10 - Tang
Chapter 12: Behavioral Finance and Technical Analysis
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Figure 19-2 Dow Theory Trends
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Chapter 12: Behavioral Finance and Technical Analysis
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Figure 19-3 Dow Jones Industrial Averages in 1988
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Chapter 12: Behavioral Finance and Technical Analysis
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Charting: Elliott Wave Theory
Elliott Wave Theory:
• Stock prices can be described by a set of
wave patterns
• Long-term and short-term wave cycles are
superimposed on each other
• By interpreting the cycles, one can predict
broad movements
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Chapter 12: Behavioral Finance and Technical Analysis
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Figure 19-4 Point and Figure Chart for Table 19-2
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Table 19-2 Stock Price History
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Figure 19-5 Point and Figure Chart for Atlantic Richfield
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Figure 19-6 Candlestick Chart
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Charting: A Warning
A Warning:
• Seeing patterns that don’t exists
• After the fact, one can always find patterns
and trading rules that would have generated
enormous profits
• What has worked in the past may not work
in the future.
Fin 2802, Spring 10 - Tang
Chapter 12: Behavioral Finance and Technical Analysis
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Figure 19-7 Actual and Simulated Stock Prices for 52 Weeks
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Chapter 12: Behavioral Finance and Technical Analysis
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Figure 19-8 Actual and Simulated Changes
in Weekly Stock Prices for 52 Weeks
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Chapter 12: Behavioral Finance and Technical Analysis
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Technical Indicators: Sentiment Indicators
• Market Volume: Higher volume gives strong confirmation
to price trend.
Volume declining/ Number declining
Trin 
Volume advancing/ Number advancing
Trin>1: Bear Market; Trin<1: Bull Market
• Odd-lot Trading (less than 100 shares): Small investors
tend to miss key market turning points.
- Odd-lot buying heavy investors should be bearish.
- Odd-lot selling heavy investors should be bullish.
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Chapter 12: Behavioral Finance and Technical Analysis
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Technical Indicators: Sentiment Indicators
• Confidence Index:
Average Yield on 10 top - rated Corporate Bonds
Average Yield on 10 intermedia te grade Corporate Bonds
– Closer to 100% investors should be bullish
– Away from 100% investors should be bearish.
• Put/Call Ratio: Ratio normally hovers around 65%.
– Rising ratio investors should be bearish?
– Rising ratio investors should be bullish?
•
Mutual Fund Cash Positions
– More cash bearish?
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Chapter 12: Behavioral Finance and Technical Analysis
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Technical Indicators: Flows of Funds
• Short Interest: The volume of short selling
High volume investors should be bearish.
Low volume investors should be bullish.
or
High volume investors should be bullish.
Low volume investors should be bearish.
• Credit Balances in Brokerage Accounts
High balance bullish
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Chapter 12: Behavioral Finance and Technical Analysis
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Market Structure Indicators
•
•
•
•
Moving Averages
Average price over some historical period (5 weeks or 200
days)
When current price crosses the average a trading signal
occurs
Bullish signal when the current price rises above the
moving average
Bearish sign when the current price falls below the
moving average
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Technical Indicators: Market Structure
Moving Average: Average over a given interval,
continuously updated.
Price
And
M.A.
Price
Bullish Signal
Bearish Signal
Moving Average
Time
Averaging interval
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Chapter 12: Behavioral Finance and Technical Analysis
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Figure 19-10 Moving Average for Microsoft
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Figure 19-11 Moving Averages
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Technical Indicators: Market Structure
• Breadth: The spread between the number of advancing
issues and the number of declining issues.
Advances > declines  bullish
Advances < declines  bearish
• Relative Strength:
Price of a Stock
Price Index for the Industry
or
Persistent Rising ratio  bullish.
Persistent Falling ratio bearish.
Fin 2802, Spring 10 - Tang
Price Index of an Industry
Market Price Index
“Momentum”
Strategies
Chapter 12: Behavioral Finance and Technical Analysis
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Figure 19-12 Cumulative Difference in Returns
of Previously Best and Worst Ranking Stocks
in Subsequent Months
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Chapter 12: Behavioral Finance and Technical Analysis
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Value Line System
• Widely followed with some evidence of superior
performance
• Value Line System is predominately a technical
system
– Earnings momentum
– Relative stock prices
– Ratios of moving averages
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Chapter 12: Behavioral Finance and Technical Analysis
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Figure 19-13 Record of Value Line Ranking for Timeliness
(without adjustment for change in rankings) 1965-1990
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Value Line System
• Paper vs actual performance indicates that the
system is difficult to implement
– Value Line Fund has not shown superior
performance
– High turnover costs are associated with the strategy
• Evidence shows prices react quickly to reported
ranking changes
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Chapter 12: Behavioral Finance and Technical Analysis
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Technical Analysis and Market Efficiency
Reaction time and length of trends
• EMH  new information is quickly
reflected in prices.
• Technical analysis long-lived trends
play out slowly and predictably.
• A useful technical rule would be
invalidated once the mass of traders
attempt to exploit it (self-destructing
Patterns)
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Chapter 12: Behavioral Finance and Technical Analysis
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A New View of Technical Analysis
EMH: Public information is available to all;
Price reflect all available information
Study by Brown and Jennings (RFS, 1989):
• Many investors have private information
• Sequence of past price can be useful in the
inference of information held by other traders
• Prices reveal as well as reflect information
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Chapter 12: Behavioral Finance and Technical Analysis
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Summary
Principles of behavioral finance, individual behavior,
behavioral explanations
Technical analysis is the search for recurring patterns in stock
prices; Technical analysis assumes prices adjust slowly
Charting: The Dow Theory
Point and Figure Charts
Elliott Wave Theory
Technical Indicators: Sentiment Indicators
Flow of Funds
Market Structure
New theories of information dissemination
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