AND MULTIFACTOR MODELS OF RISK AND RETURN
CHAPTER 12: BEHAVIORAL FINANCE AND TECHNICAL ANALYSIS
PROBLEM SETS
1. Technical analysis can generally be viewed as a search for trends or patterns in market prices. Technical analysts tend to view these trends as momentum, or gradual adjustments to ‘correct’ prices, or, alternatively, reversals of trends. A number of the behavioral biases discussed in the chapter might contribute to such trends and patterns. For example, a conservatism bias might contribute to a trend in prices as investors gradually take new information into account, resulting in gradual adjustment of prices towards their fundamental values. Another example derives from the concept of representativeness, which leads investors to
inappropriately conclude, on the basis of a small sample of data, that a pattern has been established that will continue well into the future. When investors
subsequently become aware of the fact that prices have overreacted, corrections reverse the initial erroneous trend.
2. Even if many investors exhibit behavioral biases, security prices might still be set efficiently if the actions of arbitrageurs move prices to their intrinsic values.
Arbitrageurs who observe mispricing in the securities markets would buy
underpriced securities (or possibly sell short overpriced securities) in order to profit from the anticipated subsequent changes as prices move to their intrinsic values.
Consequently, securities prices would still exhibit the characteristics of an efficient market.
3. One of the major factors limiting the ability of rational investors to take advantage of any ‘pricing errors’ that result from the actions of behavioral investors is the fact that a mispricing can get worse over time. An example of this fundamental risk is the apparent ongoing overpricing of the NASDAQ index in the late 1990s. A related factor is the inherent costs and limits related to short selling, which restrict the extent to which arbitrage can force overpriced securities (or indexes) to move towards their fair values. Rational investors must also be aware of the risk that an apparent mispricing is, in fact, a consequence of model risk; that is, the perceived mispricing may not be real because the investor has used a faulty model to value the security.
bit behavioral biases, security prices might still be set bit behavioral biases, security prices might still be set efficiently if the actions of arbitrageurs move prices to their intrinsic values.
efficiently if the actions of arbitrageurs move prices to their intrinsic values.
Arbitrageurs who observe mispricing in the securities markets would buy Arbitrageurs who observe mispricing in the securities markets would buy underpriced securities (or possibly sell sh
underpriced securities (or possibly sell sh
from the anticipated subsequent changes as prices move to their intrinsic values.
from the anticipated subsequent changes as prices move to their intrinsic values.
Consequently, securities prices would still exhibit the characteristics of an efficient inappropriately conclude, on the basis of a small sample of data, that a pattern has
to the future. When investors to the future. When investors
subsequently become aware of the fact that prices have overreacted, corrections subsequently become aware of the fact that prices have overreacted, corrections
bit behavioral biases, security prices might still be set bit behavioral biases, security prices might still be set efficiently if the actions of arbitrageurs move prices to their intrinsic values.
efficiently if the actions of arbitrageurs move prices to their intrinsic values.
Arbitrageurs who observe mispricing in the securities markets would buy Arbitrageurs who observe mispricing in the securities markets would buy
underpriced securities (or possibly sell short overpriced securities) in order to profit ort overpriced securities) in order to profit from the anticipated subsequent changes as prices move to their intrinsic values.
from the anticipated subsequent changes as prices move to their intrinsic values.
Consequently, securities prices would still exhibit the characteristics of an efficient Consequently, securities prices would still exhibit the characteristics of an efficient
One of the major factors limiting the ability of rational investors to take advantage of One of the major factors limiting the ability of rational investors to take advantage of any ‘pricing errors’ that result from the actions of behavioral investors is the fact that any ‘pricing errors’ that result from the actions of behavioral investors is the fact that a mispricing can get worse over time. An example of this fundamental risk is the a mispricing can get worse over time. An example of this fundamental risk is the apparent ongoing ove
apparent ongoing overpricing of the NASDAQ index in the late 1990s. A related rpricing of the NASDAQ index in the late 1990s. A related factor is the inherent costs and limits related to short selling, which restrict the extent
4. There are two reasons why behavioral biases might not affect equilibrium asset prices: first, behavioral biases might contribute to the success of technical trading rules as prices gradually adjust towards their intrinsic values, and second, the actions of arbitrageurs might move security prices towards their intrinsic values. It might be important for investors to be aware of these biases because either of these scenarios might create the potential for excess profits even if behavioral biases do not affect equilibrium prices.
In addition, an investor should be aware of his personal behavioral biases, even if those biases do not affect equilibrium prices, to help avoid some of these information processing errors (e.g. overconfidence or representativeness).
5. Efficient market advocates believe that publicly available information (and, for advocates of strong-form efficiency, even insider information) is, at any point in time, reflected in securities prices, and that price adjustments to new information occur very quickly. Consequently, prices are at fair levels so that active management is very unlikely to improve performance above that of a broadly diversified index portfolio. In contrast, advocates of behavioral finance identify a number of investor errors in information processing and decision making that could result in mispricing of securities. However, the behavioral finance literature generally does not provide guidance as to how these investor errors can be exploited to generate excess profits.
Therefore, in the absence of any profitable alternatives, even if securities markets are not efficient, the optimal strategy might still be a passive indexing strategy.
6. a. Davis uses loss aversion as the basis for her decision making. She holds on to stocks that are down from the purchase price in the hopes that they will recover.
She is reluctant to accept a loss.
7. a. Shrum refuses to follow a stock after she sells it because she does not want to experience the regret of seeing it rise. The behavioral characteristic used for the basis for her decision making is the fear of regret.
8. a. Investors attempt to avoid regret by holding on to losers hoping the stocks will rebound. If the stock rebounds to its original purchase price, the stock can be sold with no regret. Investors also may try to avoid regret by distancing themselves from their decisions by hiring a full-service broker.
portfolio. In contrast, advocates of behavioral finance identify a number of investor portfolio. In contrast, advocates of behavioral finance identify a number of investor mation processing and decision making that could result in mispricing mation processing and decision making that could result in mispricing of securities. However, the behavioral finance literature generally does not provide of securities. However, the behavioral finance literature generally does not provide guidance as to how these investor errors can be exploited to generate excess profits.
guidance as to how these investor errors can be exploited to generate excess profits.
the absence of any profitable alternatives, even if securities markets are the absence of any profitable alternatives, even if securities markets are not efficient, the optimal strategy might still be a passive indexing strategy.
not efficient, the optimal strategy might still be a passive indexing strategy.
a. Davis uses loss aversion as the basis for her decision making. She holds on to a. Davis uses loss aversion as the basis for her decision making. She holds on to reflected in securities prices, and that price adjustments to new information occur
kly. Consequently, prices are at fair levels so that active management is kly. Consequently, prices are at fair levels so that active management is very unlikely to improve performance above that of a broadly diversified index very unlikely to improve performance above that of a broadly diversified index portfolio. In contrast, advocates of behavioral finance identify a number of investor portfolio. In contrast, advocates of behavioral finance identify a number of investor mation processing and decision making that could result in mispricing mation processing and decision making that could result in mispricing of securities. However, the behavioral finance literature generally does not provide of securities. However, the behavioral finance literature generally does not provide guidance as to how these investor errors can be exploited to generate excess profits.
guidance as to how these investor errors can be exploited to generate excess profits.
the absence of any profitable alternatives, even if securities markets are the absence of any profitable alternatives, even if securities markets are not efficient, the optimal strategy might still be a passive indexing strategy.
not efficient, the optimal strategy might still be a passive indexing strategy.
a. Davis uses loss aversion as the basis for her decision making. She holds on to a. Davis uses loss aversion as the basis for her decision making. She holds on to are down from the purchase price in the hopes that they will recover.
are down from the purchase price in the hopes that they will recover.
She is reluctant to accept a loss.
She is reluctant to accept a loss.
a. Shrum refuses to follow a stock after she sells it because she does not want to a. Shrum refuses to follow a stock after she sells it because she does not want to experience the regret of seeing it rise. The behavioral characteristic used for the experience the regret of seeing it rise. The behavioral characteristic used for the basis for her decision making is the fear of regret.
basis for her decision making is the fear of regret.
9. a. –iv b.–iii c. – v d. – i e. –ii
10. Underlying risks still exist even during a mispricing event. The market mispricing could get worse before it gets better. Other adverse effects could occur before the price corrects itself (e.g. loss of clients with no understanding or appetite for mispricing oppo rtunities).
11. Data mining is the process by which patterns are pulled from data. Technical analysts must be careful not to engage in data mining as great is the human capacity to discern patterns where no patterns exist. Technical analysts must avoid mining data to supporta theory, rather than using data to testa theory.
12. Even if prices follow a random walk, the existence of irrational investors combined with the limits to arbitrage by arbitrageurs may allow persistent mispricings to be present. This implies that capital will not be allocated efficiently—capital does not immediately flow from relatively unproductive firms to relatively productive firms.
13. Trin =
advancing Number
/ advancing Volume
declining Number
/ declining
Volume 681, 280, 499 / 1, 434
0.958 795,587, 220 / 1, 604
This trin ratio, which is below 1.0, would be taken as a bullish signal.
14. Breadth
Breadth is positive—bullish signal (no one would actually use a one-day measure).
:
15. This exercise is left to the student; answers will vary.
16. The confidence index increases from (5%/6%) = 0.833 to (6%/7%) = 0.857.
This indicates slightly higher confidence which would be interpreted by technicians as a bullish signal. But the real reason for the increase in the index is the expectation of higher inflation, not higher confidence about the economy.
Advances Declines Net
Advances
1,604 1,434 170
using data to
Even if prices follow a random walk, the existence of irrational investors combined Even if prices follow a random walk, the existence of irrational investors combined
ts to arbitrage by arbitrageurs may allow ts to arbitrage by arbitrageurs may allow
present. This implies that capital will not be allocated efficient present. This implies that capital will not be allocated efficient
relatively unproductive firms to relatively productive firms.
relatively unproductive firms to relatively productive firms.
Number
analysts must be careful not to engage in data mining as great is the human capacity . Technical analysts must avoid mining . Technical analysts must avoid mining
a theory.
a theory.
Even if prices follow a random walk, the existence of irrational investors combined Even if prices follow a random walk, the existence of irrational investors combined
ts to arbitrage by arbitrageurs may allow
ts to arbitrage by arbitrageurs may allowpersistent mispricings persistent mispricings present. This implies that capital will not be allocated efficient
present. This implies that capital will not be allocated efficient
relatively unproductive firms to relatively productive firms.
relatively unproductive firms to relatively productive firms.
advanc advan Number Number
decliningeclining Number
This trin ratio, which is below 1.0, would be taken as a bullish signal.
This trin ratio, which is below 1.0, would be taken as a bullish signal.
Declines Declines
17. At the beginning of the period, the price of Computers, Inc. divided by the industry index was 0.39; by the end of the period, the ratio had increased to 0.50. As the ratio increased over the period, it appears that Computers, Inc. outperformed other firms in its industry. The overall trend, therefore, indicates relative strength, although some fluctuation existed during the period, with the ratio falling to a low point of 0.33 on day 19.
18. Five day moving averages:
Days 1 –5: (19.63 + 20 + 20.5 + 22 + 21.13) / 5 = 20.65 Days 2 –6 = 21.13
Days 3 –7 = 21.50 Days 4 –8 = 21.90 Days 5 –9 = 22.13 Days 6 –10 = 22.68 Days 7 –11 = 23.18