[edited]behavioral finance and technical analysis

8/14/2019 [Edited]Behavioral Finance and Technical Analysis

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CHAPTER 9: BEHAVIORAL FINANCE AND TECHNICAL

ANALYSIS

Members:

Nguyen Hong Nhung

Mai Thi Mai

Do Duc Hien

Tran Quang Huy

Vu Thi Phuong Thanh



GOALS

Introduce the behavioral finance and correspondingfindings

Identify reasons why technical analysis may beprofitable

Discuss the consistence between the technicalanalysis and the behavioral finance

Introduce several classic technical analysismethods to measure market.



9.1 THE BEHAVIORAL CRITIQUE



BEHAVIORAL FINANCE

Investors do not always process information

correctly Investors often make inconsistent or systematically

suboptimal decisions

Models of financial markets emphasize potentialimplications of psychological factors affectinginvestor behavior

The irrationalities fall into two categories:

Information Processing Problems: Investors do not alwaysprocess information correctly

Behavioral Biases: Investors often make inconsistent orsuboptimal decisions



Forecastingerrors

(Memory bias)

Overconfidence

ConservatismRepresentativ

es

Information Processing



INFORMATION PROCESSING PROBLEMS

Forecasting errors People make forecasts based on the uncertainty

inherent in their information

De Bondt and Thaler (1990) employ this notion to

explain the P/E ratio effect:Firm has had good performance recently => high earnings investors tend to forecast the firm’s future earning too

high stock price and P/E becomes relatively high , sohigh P/E stocks tend to perform poor when investorsrecognize and correct their errors




Overconfidence People tend to overestimate the precision of their

beliefs or forecasts, i.e., they tend to overestimatetheir abilities to predict future returns

For overconfident investors, trading volume may be relatively high

adjust their portfolio very frequently

Overconfident individuals often exhibit risk-seeking

behavior




Conservatism

A conservatism bias means that investors are tooslow (or said too conservative) in updating their

beliefs in response to new evidence This underreaction to news leads to momentum

effect in stock returns

Investors may underreact to news, so market prices,

determined by the consensus belief of investors, reflectnews gradually




Representativeness bias People are too prone to believe that a small sample

is representative of a population and thus infer

patterns too quickly based on small samples Example: A short-lived good earning reports would

lead investors think about the bright futureperformance, they will invest more money in the firm,exaggerating the price of stock

The forecasting errors (memory bias) can be viewedas a type of representativeness bias



BEHAVIORAL BIASES

Framing

Mental accounting Regret avoidance

Prospect theory



BEHAVIORAL BIASES

Framing effect- Investment decisions are critically dependent on the

decision-maker’s reference point.- People tend to avoid risk when a positive frame is

presented but seek risks when a negative frame is presented

Mental accounting Is a specific form of framing People segregate certain decisions Investors have a “safe” part of their portfolio that they will not

risk, and a “risky” part of their portfolio that they can have funwith

Investors segregate funds into mental accounts (e.g.,dividends and capital gains), maintain a set of separatemental accounts, and do not combine outcomes; a lossin one account is treated separately from a loss inanother account



BEHAVIORAL BIASES

Regret avoidance

Regret Prospect of regret generates avoidancebehavior

Disposition effect: investors try to avoid regret byselling stocks that have gone down in value, rush tosell those that have gone up



SMALL QUIZ Which one illustrates behavioral finance concepts: mental accounting,

overconfidence and framing?

1. If an investment falls below the purchase price, the security shouldbe retained until it returns to its original cost. Conversely, I prefer totake quick profits on successful investments

2.I’ll predict the purchase of investments, including derivatives

securities periodicially. These aggressive investments result frompersonal research and may not prove consistent with my investmentpolicy. I have not kept records on the performance of similar pastinvestment but I have had some big winners

3. Income needs should be met entirely through interest income andcash dividends. All equity securities held should pay cash dividends.



BEHAVIORAL BIASES Prospect theory

“We have an irrational tendency to be less willing togamble with profits than with losses. This meansselling quickly when we earn profits but not selling ifwe are running losses” Tvede (1999, p. 169)

The most important theory in behavioral finance They design some psychological experiments to

examine how people make decisions when they facedifferent kinds of gambles1. The results show that what affects people's decisions is not their

wealth level after the gamble, but the amount of gains or lossesfrom the gamble2. Loss averse attitude: people are more sensitive about the losses

than the gains The decrease of the utility from $1 loss is larger than the increase of the

utility from $1 gain



FIGURE 9.1 PROSPECT THEORY

※ In traditional economics, people are assumed to be risk averse and with aconcave utility function (in Diagram A)

※ In Prospect Theory, people are risk averse (thus with concave utilityfunction) when facing gains and risk loving (thus with convex utility function)when facing losses (in Diagram B)



LIMITS TO ARBITRAGE



LIMITS TO ARBITRAGE AND THE LAW OF ONE

PRICE

“Siamese twin” companies

In 1907, Royal Dutch Petroleum (RDP) and Shell

Transport (ST) merged their operations into one firm.

Split all profits from the joint company on a 60/40basis (see the figure on the next slide).

Example of fundamental risk.



FIGURE 9.2 PRICING OF RDP RELATIVE TO ST

(DEVIATION FROM PARITY)

Consistently positive deviation

lasts about 7 years

※



Equity care-outs

3com, which in 1990 decided to spin off its palm division.

Sell 5% of its stake in palm in an IPO.

3com’ price = 1.5 * palm’s price.

The day before the palm IPO, the price of 3com closedat $104.13 per share. after the first day of trading, Palmclosed at $95.06 per share (implying that the price of3com should have jumped to at least $145). Instead,3com fell to $81.81 => stub value of 3com( price of

3com – 1.5 times price of palm) is negative after the firstday of trading => mispricing

Arbitrage limited by the inability of investors to sell palmshort.



CLOSED-END FUNDS

- May sell at premium or discountto NAV => violation of the law ofone price.

- Can also be explained by rationalreturn expectations.



BUBBLES AND BEHAVIORAL ECONOMICS

From 1995 to 2001, the Nasdaq indexincreased by a factor of more than 6

This dot-com boom development could beexplained by some irrationalities in the behavioral

finance Investors were increasingly confident of their forecasts and

apparently extrapolate short-term patterns into the distantfuture (memory or representativeness bias)

The overconfidence arises from the situation in whichinvestors always earn huge capital gains regardless ofwhat to buy and when to buy

The interaction of these two biases can explain the bubblefrom 1995 to 2001



CRITIQUES FOR THE BEHAVIORAL FINANCE

Try to explain anomalies but does not giveguidance of how to exploit these irrationalities

Explain each anomaly by some subjective

combination of irrationalities from the list ofbehavioral biases. There is not a unifiedbehavioral theory to explain a range ofanomalies

It is possible to have conflicts between differenttheories, e.g., overreaction (from memory orrepresentativeness bias) vs. underreaction (formconservatism bias)



9.2 TECHNICAL ANALYSIS AND

BEHAVIORAL FINANCE

T A B



TECHNICAL ANALYSIS AND BEHAVIORAL

FINANCE

Consistence between the technical analysis andbehavioral finance Technicians believe that each adjustment takes time to

bring market price stay closely with intrinsic value =>investors possibly exploit adjustment to generate profit

Behavioral biases are also consistent with technicalanalysts’ use of volume data to form trading strategy As traders become more overconfident, they may trade more,

inducing an association between trading volume and market returns

Technicians as well as some proponents of the behavioralfinance believe that market fundamentals could beaffected by irrational or behavioral factors (labeledpsychological variables)



SOME TECHNICAL ANALYSIS METHOD

Dow theory

It is the ancestor of trendanalysis or technicalanalysis, created byCharles Dow, the founder

and first editor of the WallStreet Journal, and co-founder of Dow Jones &Company

Charles Dow



FIGURE 9.3 DOW THEORY TRENDS

Three forces simultaneously affecting stock price:

※ Primary trend: long-term movements, continuing from months to years

※ Intermediate trend (swing): short-term deviations from the underlying primarytrend, these deviations are eliminated via correct ions (when prices comeback to trend value)

※ Minor trend (swing): daily fluctuations which are with little importance in thetrend analysis of the Dow theory



DEFINITION OF “CORRECTIONS”

Optimistic attitudeof investors in

anticipating gain

More investorsbuy into trend,prices increase

The price is highenough

Buying processbecome slower

and someinvestors sell

the stock toprotect their

gains

The pricesdecrease

Correct ion is a decrease in price, following a short-termincrease

Fi 9 4 D J I d i l



Figure 9.4 Dow Jones Industrial

Averages in 1988

※ The pattern of “market peaks” (points B, D, F) and “market lows” (points A,C, E) is one of the key ways to identify the primary trend

※ Classic upward (downward) primary trend: each market peak is higher(lower) than the previous market peak (F vs. D vs. B), and each market lowis higher (lower) than the previous market low (E vs. C vs. A)




Point and figure charts

In a rising (falling) trend, whenever the stock price increases(decreases) by, for example $2, mark an X (O)corresponding to the current stock price in the grid of thepoint and figure chart (see the figure on the next slide)

It simply traces significant upward or downward movementsin stock prices without regard to their timing

Different from other technical analysis, this chart has no timedimension

Instead, the aim of this chart is to filter out the “noise” (unimportant price movement) and focus on finding the maindirection of the price trend

T 9 1 S P H F 9 5



TABLE 9.1 STOCK PRICE HISTORY FIGURE 9.5

POINT AND FIGURE CHART

※ Here the minimal movement of stock prices recorded in the point and figure chart is$2, which is customary in setting up a chart to record significant price changes

Support Resistanc



FIGURE 9.6 POINT AND FIGURE CHART FOR DJIA IN 1988

※ An congestion area is a horizontal band created by several price reversals, i.e.,consisting of alternate columns of X’s and O’s, and the upper and lower boundsfor an congestion area correspond to the resistance and support levels

※ When the stock price penetrates the resistance level from below, it means themarket considers about the prospect of the stock is significantly better than that

in the previous congestion period and thus a buy signal is generated.

Buy Signal

Sell Signal



SOME TECHNICAL ANALYSIS METHOD Moving averages

For each day, the moving average of a specified period oftime, e.g., 4 weeks, is recomputed by dropping the oldestobservation and adding the latest

By definition, the long-term moving average is a moresmooth series than the short-term moving average

When the short-term moving average crosses the long-term moving average, a trading signal occursBullish (bearish) signals occur when the short-term upward moving

average penetrates the long-term upward moving average frombelow (above)

This is because when the recent performance is significantly

superior (inferior) to the past performance in a longer period, it isexpected that this time point is the beginning of a rising (falling) trend




Breadth

The extent to which the market trend is reflectedwidely in movements of individual stocks

Breadth is measured as the difference betweenthe number of advancing stocks and declining

stocks If the advances outnumber declines by a wide

margin, then the market is viewed as beingstronger because the upward rally is widespread

(see the next slide)



TABLE 9.2 BREADTH

※ The direction of the cumulated breadth series is used to discernmarket trends

※ When the cumulative breadth increases (decreases), the market is

viewed as being stronger (weaker) because the upward (downward)rally is more widespread

※ Analysts might use a moving average of cumulative breadth togauge market trends



SOME TECHNICAL ANALYSIS METHOD Relative strength

Defined as the ratio of prices of an individual stockover the level of an industry index A rising (falling) ratio implies security has

outperformed (underperfomed) the particularindustry average and generates a signal to buy (sell)(making profit if the relative strength can persist overtime)

Buy relatively strong and short relatively weakstocks in the same industry: the market and industry

risks can be eliminated and earn purely thedifference between the performance of these twostocksE.g., buy shares of TSMC and short shares of UMC



SENTIMENT INDICATORS



SENTIMENT INDICATORS: TRIN

STATISTIC

Volume declining/Number decliningTrin =

Volume advancing/Number advancing

Average volume for falling stocks=

Average volume for rising stocks

- TRading Index- Trin > 1 : Bear market- Trin<1: Bull Market



SENTIMENT INDICATORS: CONFIDENT

INDEX

BondsCorporategradeteintermedia10onYieldAverage

BondsCorporaterated-top10onYieldAverage

- This ratio is always smaller than 1 becausehigher rated bonds will offer lower promisedyields to maturity

- Closer to 100% => investors should bebullish

- Away from 100% => investors should be

bearish



SENTIMENT INDICATORS: SHORT

INTEREST

- Short interest – total number of shares that are sold-

short in the market- Short sale: the sale of shares not owned by the

investor but borrowed through a broker and later

purchased to replace the loan- High volume => investors should be bearish.

Low volume => investors should be bullish.

or

- High volume: investors should be bullish.

Low volume: investors should be bearish.



SENTIMENT INDICATORS: PUT /CALL

RATIO

- Puts are the right to sell.

- Calls are the right to buy.

- Put/call ratio: The ratio of outstanding put options tooutstanding call options

- Put options do well in falling markets. Call options

do well in rising market=>Rising ratio : bearish

Falling ratio: bullish

[edited]behavioral finance and technical analysis

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