Behavioral Finance and Technical Analysis

CHAPTER 9 9.1 THE BEHAVIORAL CRITIQUE Behavioral Finance and Technical Analysis Behavioral Finance Investors do not always process information correctly Investors often make inconsistent or systematically suboptimal decisions Behavioral Biases Information Processing Critique Forecasting errors Overconfidence Conservatism Sample size neglect and representativeness Figure 9.1 Prospect Theory Framing Mental accounting Regret avoidance Prospect theory 19-1 Limits to Arbitrage Fundamental risk Implementation costs Model risk Figure 9.2 Pricing of Royal Dutch Relative to Shell (Deviation from Parity) Limits to Arbitrage and the Law of One Price Siamese twin companies Equity carvecarve-outs ClosedClosed-end funds Bubbles and Behavioral Economics As the dotdot-com boom developed, it seemed to feed on itself Investors were increasingly confident of their investment prowess Evaluation of the Behavioral Critiques Arguments that the evidence does not support one type of irrationality Relatively new field 9.2 TECHNICAL ANALYSIS AND BEHAVIORAL FINANCE 19-2 Trends and Corrections Dow theory Point and figure charts Trends and Corrections Trends and Corrections 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 Figure 9.3 Dow Theory Trends 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 Table 9.1 Stock Price History Figure 9.4 Point and Figure Chart for Table 9.1 19-3 Figure 9.5 Point and Figure Chart for Atlantic Richfield Figure 9.6 Dow Jones Industrial Averages in 1988 Figure 9.7 Share Price and 50-Day Moving Average for Apple Computer Figure 9.8 Level of the DJIA and the 5Week Moving Average Figure 9.8 Moving Averages Table 9.2 Breadth 19-4 Sentiment Indicators Trin Statistics: Volume declining/Number declining Trin = Volume advancing/Number advancing Relative strength – Measures the extent to which a security has outperformed or underperformed either the market or its industry Sentiment Indicators Short Interest - total number of shares that are sold short – When short sales are high a signal occurs – Bullish interpretation – Bearish interpretation Figure 9.10 Actual and Simulated Levels for Stock Market Prices of 52 Weeks Sentiment Indicators Confidence index – Ratio of the average yield on 10 toptop-rated corporate bonds divided by the average yield on 10 intermediateintermediate-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 A Warning Although the ability to discern apparent patterns with stock market prices is irresistible— irresistible—it is also possible to perceive patterns that may not exist Figure 9.11 Actual and Simulated Changes in Weekly Stock Prices for 52 Weeks 19-5