Chapter Twelve

Chapter Twelve

Behavioral Finance and Technical Analysis

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Conventional vs. behavioral finance Information processing and behavioral irrationalitiesLimits to arbitrage and bubbles in behavioral economicsTechnical analysis and strategies

Chapter Overview

Behavioral Finance

Conventional Finance

Prices are correct and equal to intrinsic value Resources are allocated efficientlyConsistent with EMH

Behavioral Finance

What if investors

don

’

t

behave rationally?

Two categories of irrationalities:Investors do not always process information correctlyResult: Incorrect probability distributions of future returnsEven when given a probability distribution of returns, investors may make inconsistent or suboptimal decisionsResult: They have behavioral biases

The Behavioral Critique

Forecasting Errors: Too much weight is placed on recent experiencesOverconfidence: Investors overestimate their abilities and the precision of their forecastsConservatism: Investors are slow to update their beliefs and under react to new informationSample Size Neglect and Representativeness: Investors are too quick to infer a pattern or trend from a small sample

Errors in Information Processing: Misestimating True Probabilities

FramingHow the risk is described, “risky losses” vs. “risky gains,” can affect investor decisionsMental AccountingInvestors may segregate accounts or monies and take risks with their gains that they would not take with their principal

Behavioral

Biases: Examples

Regret AvoidanceInvestors blame themselves more when an unconventional or risky bet turns out badlyProspect TheoryConventional view: Utility depends on level of wealthBehavioral view: Utility depends on changes in current wealth

Behavioral Biases: Examples

Figure 12.1 Prospect Theory

Behavioral biases would not matter if rational arbitrageurs could fully exploit the mistakes of behavioral investorsFundamental Risk: “Markets can remain irrational longer than you can remain solvent”Intrinsic value and market value may take too long to converge

Limits to Arbitrage

Implementation Costs:Transactions costs and restrictions on short selling can limit arbitrage activityModel Risk:What if you have a bad model and the market value is actually correct?

Limits to

Arbitrage

Siamese Twin CompaniesRoyal Dutch should sell for 1.5 times ShellHave deviated from parity ratio for extended periodsExample of fundamental risk

Limits to Arbitrage and the

Law of One Price

Figure 12.2 Pricing of Royal Dutch Relative to Shell

Equity Carve-outs3Com and PalmArbitrage limited by availability of shares for shortingClosed-End FundsMay sell at premium or discount to NAVCan also be explained by rational return expectations

Limits to Arbitrage and the

Law of One

Price

Bubbles are easier to spot after they endDot-com bubbleHousing bubble

Bubbles and Behavioral Economics

Bubbles and Behavioral Economics

Rational explanation for stock market bubble using the dividend discount model:

S&P 500 is worth $12,883 million if dividend growth rate is 8% (close to actual value in 2000)S&P 500 is worth $8,589 million if dividend growth rate is 7.4% (close to actual value in 2002)

Technical analysis attempts to exploit recurring and predictable patterns in stock pricesPrices adjust gradually to a new equilibriumMarket values and intrinsic values converge slowlyDisposition effect: The tendency of investors to hold on to losing investmentsDemand for shares depends on price historyCan lead to momentum in stock prices

Technical Analysis and

Behavioral

Finance

Momentum and moving averagesThe moving average is the average level of prices over a given interval of time, where the interval is updated as time passesBullish signal: Market price breaks through the moving average line from below, it is time to buyBearish signal: When prices fall below the moving average, it is time to sell

Technical Analysis:

Trends

and

Corrections

Figure 12.3 Moving Average for INTC

Relative strengthMeasures the extent to which a security has out- or underperformed either the market as a whole or its particular industryPricing ratio implies outperformance

Technical Analysis:Relative Strength

Technical Analysis:Relative Strength

Breadth Often measured as the spread between the number of stocks that advance and decline in price

Trin StatisticRatios above 1.0 are bearish

Technical Analysis:Sentiment Indicators

Confidence IndexThe ratio of the average yield on 10 top-rated corporate bonds divided by the average yield on 10 intermediate-grade corporate bondsHigher values are bullish

Technical Analysis:

Sentiment Indicators

Technical Analysis:Sentiment Indicators

Put/Call Ratio

Calls are the right to buyA way to bet on rising pricesPuts are the right to sellA way to bet on falling prices

A rising ratio may signal investor pessimism and a coming market decline

Contrarian investors see a rising ratio as a buying opportunity

It is possible to perceive patterns that really don’t existFigure 12.6A is based on the real dataThe graph in panel B was generated using “returns” created by a random-number generatorFigure 12.7 shows obvious randomness in the weekly price changes behind the two panels in Figure 12.6

Technical Analysis:

A Warning

Figure 12.6 Actual and Simulated Levels for Stock Market Prices of 52 Weeks

Figure 12.7 Actual and Simulated Changesin Stock Prices for 52 Weeks