CHAPTER 19
Behavioral Finance and
Technical Analysis
Behavioral Finance
Traditional theory ignores some aspects
of personal behavior
Behavioral finance tries to incorporate
personal behavior to extend corporate
finance
Behavioral finance is a developing area
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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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Asset Returns and
Behavioral Explanations
Calendar effects
Cash dividends
Overreaction and mean reversion
Controversial explanations from
behavioral finance
– Closed-end fund pricing
– Excess volatility in stock prices
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Sample Price Chart
Price
High
Close
Low
Days
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Point and Figure Chart
Price
x
Congestion areas
x
x o x
o
o x
x o x o
x o
o
x
o x
o
o
Sell
o x o x
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x o
o x o
o
o
o
o
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Sentiment Indicators
Trin Statistics
# Advancing / # Declining
Volume Advancing / Volume Declining
# Declining / Volume Declining
# Advancing / Volume Advancing
If Trin > 1.0 bearish signal
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Sentiment Indicators
Put / Call Ratio
– Historical value 65%
– When higher than 65% a signal occurs
Bearish view
Bullish view
Mutual Fund Cash Position
– Cash levels are low - bearish sign
– Cash levels are high - bullish sign
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Sentiment Indicators
Odd - Lot Trading
Ratio of odd-lot purchases to odd-lot
sales
When ratio exceeds 1.0, bearish sign
Contrarian logic - small investors are the
last to buy in bull markets
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Flow of Funds Indicators
Short Interest - total number of shares that are
sold short
– When short sales are high a signal occurs
– Bullish interpretation
– Bearish interpretation
Credit Balances in Brokerage Accounts
– Investor leave balances when they plan to invest in
the future
– When levels are high a bullish sign
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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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Market Structure
Indicators
Breadth
The extent to which movements in a
broad index are reflected widely in
movements of individual stocks
Spread between advancing stocks and
declining stocks
Also used in industry indexes
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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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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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