Chapter 9 investments behavioral finance and technical analysis

Behavioralism bias• Motivation - Stock prices in the 1990s did not appear to match “fundamentals,” e.g., high price earnings ratios - Economics discipline is exploring behavioral aspects

Chapter 9

Behavioral Finance

and Technical

Analysis

9.1 The Behavioral Critique

Behavioralism bias

• Motivation

- Stock prices in the 1990s did not appear to match “fundamentals,”

e.g., high price earnings ratios

- Economics discipline is exploring behavioral aspects of decision making

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• Extrapolation bias

• Overconfidence

- Analysts tend to excessively extrapolate historical trends when forecasting.

- May lead to unsustainably high P/E ratios.

- Some people exhibit overconfidence in their ability to pick stocks or have an exaggerated belief that ‘risk’ will hurt the other person but not them As a result, they bid stock prices too high.

• Anchoring Bias & earnings

- Many people become anchored to their ideas and will not update their expectations when new information ar-rives

- This underreaction to news leads to momentum in stock returns

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Why not arbitrage mispriced sto cks?

• If some investors are letting behavioral biases affect prices, why don’t other better trained investors eng

age in profitable arbitrage?

Limits to arbitrage

• Fundamental Risk

• Short sale constraints

• Model Risk

Changes in fundamentals can wipe out any arbi-trage profits, making the strategy risky

Short sale constraints make it difficult to arbitrage overpriced securities

How do you know when a security is truly mis-priced? Your model may be giving you wrong sig-nals 9-7

Critiquing the Behavioral Critique

• It provides stories that fit individual situations but there is no coherent theory put forth and

some behaviors contradict others

• Much of the empirical support for the behavioralist ideas in investments comes from one specific time period, the late 1990s

• The behavioral literature is very weak at providing solutions to these problems

9.2 Technical Analysis and Behavioral Finance

• Attempts to exploit recurring and predictable patterns in stock prices to generate superior investment performance

• Technicians do not deny the value of fundamental information, but belie

ve that prices only gradually close in on intrinsic value

- As fundamentals shift, astute traders can exploit the adjustment to a new

equilibrium

• Technicians believe that market fundamentals can be perturbed by irrati onal or behavior factors.

- Random price fluctuations will accompany any underlying price trend, creating opportunities to exploit corrections as these fluctuations dissi pate

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Basic Types of Technical Analysi s

Dow Theory

• Three types of trends, only two are important

• Every stock has price peaks and troughs but if a series of peaks and troughs are rising, it is a buy signal especially if

Basic Types of Technical Analysi s

Dow Theory

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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 or its particular industry and could indicate a buy or bullish signal

• If relative strength can be assumed to persist over time, then this would be a signal to buy it

ΔP i / ΔIndex

A Warning About Identifying Tren ds

• Difficulty in identifying common price patterns

One of these patterns is real and one of these is computer simulated with random price

changes Can you tell which is which?

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