Behavioral Finance and Technical Analysis

Behavioral Finance and Technical
Analysis
Behavioral Finance, Definition.
• Behavioral Finance The area of research that attempts to
understand and explain how reasoning errors influence
investor decisions and market prices.
• Much of behavioral finance research stems from the
research in the area of cognitive psychology.
– Cognitive psychology: the study of how people (including
investors) think, reason, and make decisions.
– Reasoning errors are often called cognitive errors.
• Some people believe that cognitive (reasoning) errors
made by investors will cause market inefficiencies.
9- 2
Economic Conditions that Lead to Market
Efficiency
1)Investor rationality
2)Independent deviations from rationality
3)Arbitrage
• For a market to be inefficient, all three conditions must be
absent. That is,
– it must be that many, many investors make irrational
investment decisions, and
– the collective irrationality of these investors leads to an
overly optimistic or pessimistic market situation, and
– this situation cannot be corrected via arbitrage by rational,
well-capitalized investors.
• Whether these conditions can all be absent is the subject of a
raging debate among financial market researchers.
9- 3
Behavioral Finance
Conventional Finance Behavioral Finance

• Prices are correct; equal • What if investors don’t
to intrinsic value. behave rationally?
• Resources are allocated
efficiently.
• Consistent with EMH
The Behavioral Critique
Two categories of irrationalities:
1. Investors do not always process information
correctly.
• Result: Incorrect probability distributions
of future returns.
2. Even when given a probability distribution of
returns, investors may make inconsistent or
suboptimal decisions.
• Result: They have behavioral biases.
Errors in Information Processing: Misestimating
True Probabilities
1. Forecasting Errors: Too 3. Conservatism: Investors
much weight is placed are slow to update their
on recent experiences. beliefs and under react to
new information.
2. Overconfidence:
Investors overestimate 4. Sample Size Neglect and
their abilities and the Representativeness:
precision of their Investors are too quick to
forecasts. infer a pattern or trend
from a small sample.
Prospect Theory
• Prospect theory provides an alternative to
classical, rational economic decision-making.
•
• The foundation of prospect theory: investors
are much more distressed by prospective
losses than they are happy about prospective
gains.
Prospect Theory contd.
– Researchers have found that a typical investor considers the pain of a
$1 loss to be about twice as great as the pleasure received from the
gain of $1.
– Also, researchers have found that investors respond in different ways
to identical situations.
– The difference depends on whether the situation is presented in
terms of losses or in terms of gains.
– Investors tend to be risk-averse with regard to gains but risk taking
when it comes to losses.
• Three major judgment errors consistent with the predictions of prospect
theory.
– Frame Dependence
– Mental Accounting
– The House Money Effect
Prospect Theory.
• Prospect theory provides an alternative to classical, rational
economic decision-making.
• The foundation of prospect theory: investors are much more
distressed by prospective losses than they are happy about
prospective gains.
– Researchers have found that a typical investor considers the pain of a $1
loss to be about twice as great as the pleasure received from the gain of
$1.
– Also, researchers have found that investors respond in different ways to
identical situations.
– The difference depends on whether the situation is presented in terms of
losses or in terms of gains.
– Investors tend to be risk-averse with regard to gains but risk taking when it
comes to losses.
• Three major judgment errors consistent with the predictions of prospect
theory.
– Frame Dependence
– Mental Accounting
– The House Money Effect
9- 9
Behavioral Biases
• Biases result in less than rational
decisions, even with perfect information.
Examples:
1.Framing:
– How the risk is described, “risky losses” vs.
“risky gains”, can affect investor decisions.
Behavioral Biases
2. Mental Accounting:
• Investors may segregate accounts or monies
and take risks with their gains that they
would not take with their principal.
3. Regret Avoidance:
• Investors blame themselves more when an
unconventional or risky bet turns out badly.
Behavioral Biases
4. Prospect Theory:
– Conventional view: Utility depends on level of
wealth.
– Behavioral view: Utility depends on changes in
current wealth.
Limits to Arbitrage
• Behavioral biases would not matter if
rational arbitrageurs could fully exploit
the mistakes of behavioral investors.
• Fundamental 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 activity.
• Model Risk:
– What if you have a bad model and the market
value is actually correct?
Bubbles and Behavioral Economics
• Bubbles are easier to spot after they

end.
– Dot-com bubble
– Housing bubble
Bubbles and Behavioral Economics
• Rational explanation for • S&P 500 is worth $12,883
stock market bubble using million if dividend growth
the dividend discount rate is 8% (close to actual
model: value in 2000).
D1 • S&P 500 is worth $8,589

PV0 
kg million if dividend growth
rate is 7.4% (close to
actual value in 2002).
Technical Analysis and Behavioral Finance
• Technical analysis attempts to exploit

recurring and predictable patterns in stock
prices.
– Prices adjust gradually to a new equilibrium.
– Market values and intrinsic values converge
slowly.
Technical Analysis and Behavioral Finance
• Disposition effect: The tendency of investors

to hold on to losing investments.
– Demand for shares depends on price history

– Can lead to momentum in stock prices
Trends and Corrections:
The Search for Momentum
Dow Theory
1. Primary trend : Long-term movement of
prices, lasting from several months to several
years.
2. Secondary or intermediate trend: short-term
deviations of prices from the underlying trend
line and are eliminated by corrections.
3. Tertiary or minor trends: Daily fluctuations of
little importance.
Figure 12.3 Dow Theory Trends
Trends and Corrections: Moving Averages
• The moving average is • Bullish signal: Market

the average level of price breaks through
prices over a given the moving average line
interval of time. from below. Time to
buy
• Bearish signal: When
prices fall below the
moving average, it is
time to sell.
Figure 12.5 Moving Average for HPQ
Trends and Corrections: Breadth
Breadth: Often
measured as the
spread between
the number of
stocks that
advance and
decline in price.
Sentiment Indicators:
Confidence Index
• Confidence index: The • Higher values are
ratio of the average bullish.
yield on 10 top-rated
corporate bonds
divided by the average
yield on 10
intermediate-grade
corporate bonds.
Figure 12.9 Actual and Simulated Changes in
Stock Prices for 52 Weeks

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Behavioral Finance and Technical

Conventional Finance Behavioral Finance

• Bubbles are easier to spot after they

D1 • S&P 500 is worth $8,589

• Technical analysis attempts to exploit

• Disposition effect: The tendency of investors

– Demand for shares depends on price history

• The moving average is • Bullish signal: Market

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