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• 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
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• 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.
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• 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.
9-4

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.
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• 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.
Hedging in details; will be in Excel exam
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• 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.
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9.2Technical Analysis and Behavioral
Finance
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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
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http://www.spreadsheetml.com/chart/freepointandfigure.shtml
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2. Identifying trends using moving averages
Crossing the SMA from above is a bear signal; from below is a bull signal.
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3. Dow Theory http://thedowtheory.com/Description&results.html
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Basic Types of Technical Analysis
4. Relative Strength
A simple relative strength ratio could be constructed as
/ ΔIndex
Increases in the relative strength ratio indicate the stock is outperforming the index and could indicate a buy or bullish signal.
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5. Breadth
– Measured as the difference between the number of advancing and declining stocks
– Also used in industry indexes
• 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.
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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.
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8. Trin Statistic
Volume declining/Number declining
Trin =
Volume advancing/Number advancing
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• 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
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A Warning About Identifying
Trends
• Difficulty in identifying common price patterns
• Less than meets the eye
• Data mining
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