1 fin 2802, spring 10 - tang chapter 12: behavioral finance and technical analysis fin2802:...

1Fin 2802, Spring 10 - TangChapter 12: Behavioral Finance and Technical Analysis

Fin2802: Investments

Spring, 2010Dragon Tang

Fin2802: Investments

Spring, 2010Dragon TangLectures 11&12

Behavioral Finance and Technical Analysis

February 23&25, 2010

Readings: Chapter 12Practice Problem Sets: 1,2,4,10, 11


Where Are We?Where Are We?

How?SecuritiesMarkets

InstitutionsTrading

Delegated investment

Why?Market efficiency

Historical performance

What?StockBond

EvaluationInternational


Where Are We?Where Are We?How?

SecuritiesMarkets

InstitutionsTrading

Delegated investmentWhy?

Market efficiency Historical performance

What?StockBond

EvaluationInternational

So What?


Behavioral Finance and Technical AnalysisBehavioral Finance and Technical Analysis

Objectives:

1. Understand the principles of behavioral finance.

2. Identify reasons why technical analysis may be profitable.

3. Use the Dow theory to identify situations that technicians would characterize as buy or sell opportunities.

4. Use indicators such as volume, breadth, short interest, or confidence indexes to measure the "technical condition" of the market.

5. Explain why most of technical analysis is at odds with an efficiently functioning stock market.


Behavioral FinanceBehavioral Finance

• Traditional theories (e.g., CAPM) assume rational investors

• Systematic behavioral biases (anomalies) have been observed

• Behavioral finance tries to incorporate some aspect of investors’ behavior and explain those anomalies using psychological principles

• It is a developing and important area

• Companies exploiting behavioral biases:

Lakonishok, Shleifer and Vishny (LSV)

Dimensional Fund Advisors (DFA)

Fuller and Thaler Asset Management

Case-Shiller-Weiss


Individual BehaviorIndividual Behavior

• Cooperation and Altruism

• Bidding and the Winner’s Curse

• Endowment Effect, Status Quo Bias and Loss Aversion

• Mental Accounts


Figure 12-1 Loss Aversion Preference FunctionFigure 12-1 Loss Aversion Preference Function


Asset Returns and Behavioral ExplanationsAsset Returns and Behavioral Explanations

• Calendar Effects

• Cash Dividends

• Overreaction and Mean Reversion

• Controversial explanations from behavioral finance

– Closed-end fund discount puzzle– Excess volatility in stock prices– Loss aversion

9

Limits to ArbitrageLimits to Arbitrage

• Fundamental Risk

• Implementation Costs

• Model Risk

• Siamese Twin Companies

• Equity Carve-outs

• Closed-End Funds

Fin 2802, Spring 10 - TangChapter 12: Behavioral Finance and Technical Analysis

10

Figure 12.2 Pricing of Royal Dutch Relative to Shell (Deviation from Parity)Figure 12.2 Pricing of Royal Dutch Relative to Shell (Deviation from Parity)

Fin 2802, Spring 10 - TangChapter 12: Behavioral Finance and Technical Analysis


Technical AnalysisTechnical Analysis

• Attempts to exploit stock price patterns for profit.

• Assumes prices adjust slowly to their true equilibrium values


Technical Analysis and EMHTechnical Analysis and EMH

• Technical analysis clashes with the EMH hypothesis.

• EMH predicts rapid adjustment of prices with the onset of new information.

• Evidence for the success of technical analysis is poor.


Technical Analysis Tool-kitTechnical Analysis Tool-kit• Charting: The analysis of “charts” of stock price

and volume with the hope of finding patterns to exploit in the markets.

– The Dow Theory– Point and Figure Chart– Elliott Wave Theory

• Technical Indicators– Sentiment Indicators: Market Volume (Trin Statistic); Odd-

lot Trading; Confidence Index; Put/Call Ratio; Mutual Fund Cash Position

– Flow of Funds: Short Interest; Credit balances in brokerage accounts

– Market Structure: Moving Averages; Breadth; Relative Strength;


Charting: The Dow TheoryCharting: The Dow Theory

The Dow Theory:

•Uses price and volume trends to predict stock prices.

•Identifies primary, secondary, and tertiary trends.

•Predicts support and resistance price levels.


Figure 19-2 Dow Theory TrendsFigure 19-2 Dow Theory Trends


Figure 19-3 Dow Jones Industrial Averages in 1988Figure 19-3 Dow Jones Industrial Averages in 1988


Charting: Elliott Wave TheoryCharting: Elliott Wave Theory

Elliott Wave Theory:

• Stock prices can be described by a set of wave patterns

• Long-term and short-term wave cycles are superimposed on each other

• By interpreting the cycles, one can predict broad movements


Figure 19-4 Point and Figure Chart for Table 19-2 Figure 19-4 Point and Figure Chart for Table 19-2


Table 19-2 Stock Price HistoryTable 19-2 Stock Price History


Figure 19-5 Point and Figure Chart for Atlantic RichfieldFigure 19-5 Point and Figure Chart for Atlantic Richfield


Figure 19-6 Candlestick ChartFigure 19-6 Candlestick Chart


Charting: A WarningCharting: A Warning

• Seeing patterns that don’t exists

• After the fact, one can always find patterns and trading rules that would have generated enormous profits

• What has worked in the past may not work in the future.

A Warning:


Figure 19-7 Actual and Simulated Stock Prices for 52 WeeksFigure 19-7 Actual and Simulated Stock Prices for 52 Weeks


Figure 19-8 Actual and Simulated Changes in Weekly Stock Prices for 52 Weeks

Figure 19-8 Actual and Simulated Changes in Weekly Stock Prices for 52 Weeks


Technical Indicators: Sentiment IndicatorsTechnical Indicators: Sentiment Indicators

• Market Volume: Higher volume gives strong confirmation to price trend.

Trin>1: Bear Market; Trin<1: Bull Market

• Odd-lot Trading (less than 100 shares): Small investors tend to miss key market turning points.

- Odd-lot buying heavy investors should be bearish.

- Odd-lot selling heavyinvestors should be bullish.

advancingNumber advancing/ Volume

decliningNumber declining/ VolumeTrin


Technical Indicators: Sentiment IndicatorsTechnical Indicators: Sentiment Indicators

• Confidence Index:

– Closer to 100% investors should be bullish– Away from 100% investors should be bearish.

• Put/Call Ratio: Ratio normally hovers around 65%.– Rising ratio investors should be bearish?– Rising ratio investors should be bullish?

• Mutual Fund Cash Positions– More cash bearish?

Bonds Corporate grade teintermedia 10on Yield Average

Bonds Corporate rated- top10on Yield Average


Technical Indicators: Flows of FundsTechnical Indicators: Flows of Funds

• Short Interest: The volume of short selling

High volume investors should be bearish.

Low volumeinvestors should be bullish. or

High volume investors should be bullish.

Low volumeinvestors should be bearish.

• Credit Balances in Brokerage Accounts

High balance bullish


Market Structure IndicatorsMarket Structure Indicators

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


Technical Indicators: Market StructureTechnical Indicators: Market Structure

Moving Average: Average over a given interval, continuously updated.

PriceAndM.A.

Time

Price

Moving Average

Averaging interval

Bearish Signal

Bullish Signal


Figure 19-10 Moving Average for MicrosoftFigure 19-10 Moving Average for Microsoft


Figure 19-11 Moving AveragesFigure 19-11 Moving Averages


Technical Indicators: Market StructureTechnical Indicators: Market Structure

• Breadth: The spread between the number of advancing issues and the number of declining issues.

Advances > declines bullish

Advances < declines bearish

• Relative Strength: or

Persistent Rising ratio bullish.

Persistent Falling ratio bearish.

Industry for theIndex Price

Stock a of PriceIndex PriceMarket

Industryan ofIndex Price

“Momentum” Strategies


Figure 19-12 Cumulative Difference in Returns of Previously Best and Worst Ranking Stocks

in Subsequent Months

Figure 19-12 Cumulative Difference in Returns of Previously Best and Worst Ranking Stocks

in Subsequent Months


Value Line SystemValue Line System

• Widely followed with some evidence of superior performance

• Value Line System is predominately a technical system– Earnings momentum

– Relative stock prices

– Ratios of moving averages


Figure 19-13 Record of Value Line Ranking for Timeliness (without adjustment for change in rankings) 1965-1990

Figure 19-13 Record of Value Line Ranking for Timeliness (without adjustment for change in rankings) 1965-1990


Value Line SystemValue Line System

• Paper vs actual performance indicates that the system is difficult to implement– Value Line Fund has not shown superior

performance

– High turnover costs are associated with the strategy

• Evidence shows prices react quickly to reported ranking changes


Technical Analysis and Market EfficiencyTechnical Analysis and Market Efficiency

Reaction time and length of trends

• EMH new information is quickly reflected in prices.

• Technical analysis long-lived trends play out slowly and predictably.

• A useful technical rule would be invalidated once the mass of traders attempt to exploit it (self-destructing Patterns)


A New View of Technical AnalysisA New View of Technical Analysis

EMH: Public information is available to all; Price reflect all available information

Study by Brown and Jennings (RFS, 1989):

• Many investors have private information

• Sequence of past price can be useful in the inference of information held by other traders

• Prices reveal as well as reflect information


SummarySummary

Principles of behavioral finance, individual behavior, behavioral explanations

Technical analysis is the search for recurring patterns in stock prices; Technical analysis assumes prices adjust slowly

Charting: The Dow Theory Point and Figure Charts

Elliott Wave Theory

Technical Indicators: Sentiment IndicatorsFlow of Funds

Market Structure

New theories of information dissemination

1 fin 2802, spring 10 - tang chapter 12: behavioral finance and technical analysis fin2802:...

Documents

technical analysis slide

tang chapter

technical analysis figure

technical analysis fin2802

technical analysis objectives

technical condition

investments spring

parity fin