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Behavioral Finance and Technical Analysis

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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 – PowerPoint PPT presentation

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Title: Behavioral Finance and Technical Analysis


1
Chapter 9
  • Behavioral Finance and Technical Analysis

2
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
9-2
3
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.
9-3
4
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.

9-4
5
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.

9-5
6
Why not arbitrage mispriced stocks?
  • If some investors are letting behavioral biases
    affect prices, why dont other better trained
    investors engage in profitable arbitrage?

Part of reason for growth in hedge funds. Hedging
in details will be in Excel exam
9-6
7
Limits to arbitrage
  • Fundamental Risk
  • Short sale constraints
  • Model Risk

Changes in fundamentals can wipe out any
arbitrage profits, making the strategy risky.
Short sale constraints make it difficult to
arbitrage overpriced securities.
How do you know when a security is truly
mispriced? Your model may be giving you wrong
signals.
9-7
8
  • 9.2Technical Analysis and Behavioral Finance

9-8
9
Technical Trading Rules
  • 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

9-9
10
Point Figure Charts http//www.spreadsheetml.com
/chart/freepointandfigure.shtml
9-10
11
Basic Types of Technical Analysis
  • Identifying trends using moving averages

Crossing the SMA from above is a bear signal
from below is a bull signal.
9-11
12
Basic Types of Technical Analysis
  • Dow Theory http//thedowtheory.com/Descriptionres
    ults.html

9-12
13
Basic Types of Technical Analysis
  • Relative Strength

A simple relative strength ratio could be
constructed as ___________. Increases in the
relative strength ratio indicate the stock is
outperforming the index and could indicate a buy
or bullish signal.
?Pi / ?Index
9-13
14
Basic Types of Technical Analysis
  • 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
    days net advances or declines to the previous
    days total. The purpose is to gauge the trend.

9-14
15
TA Sentiment Indicators
  • Short Interest
  • Total number of shares of stock currently sold
    short
  • High short interest may indicate that a stocks
    price is expected to fall.

9-15
16
TA Sentiment Indicators
  • Trin Statistic

9-16
17
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

9-17
18
A Warning About Identifying Trends
  • Difficulty in identifying common price patterns
  • Less than meets the eye
  • Data mining

9-18
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