Chapter 9 investments behavioral finance and technical analysis

Chapter 9 Behavioral Finance and Technical Analysis 9.1 The Behavioral Critique 9-2 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 9-3 Behavioralism 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. 9-4 Behavioralism Anchoring Bias & earnings - Many people become anchored to their ideas and will not update their expectations when new information arrives. - This underreaction to news leads to momentum in stock returns. 9-5 Why not arbitrage mispriced stocks? If some investors are letting behavioral biases affect prices, why don’t other better trained investor s engage in profitable arbitrage? 9-6 Limits to arbitrage Fundamental Risk Short sale constraints Model Risk Changes in fundamentals can wipe out any arbitrage profits, making the strategy risky. Short sale constraints make it difficult to arbitrage overpriced securities. How do you know when a security is truly mispriced? Your model may be giving you wrong signals. 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. 9-8 9.2. Technical Analysis and Behavioral Finance Attempts to exploit recurring and predictable patterns in stock prices to gene rate superior investment performance. Technicians do not deny the value of fundamental information, but believe th at prices only gradually close in on intrinsic value. - As fundamentals shift, astute traders can exploit the adjustment to a ne w equilibrium. Technicians believe that market fundamentals can be perturbed by irrational or behavior factors. - Random price fluctuations will accompany any underlying price trend, creating opportunities to exploit corrections as these fluctuations dissipat e. 9-9 Basic Types of Technical Analysis 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 volume is heavier during the peaks than the troughs 9-10 [...]...Basic Types of Technical Analysis Dow Theory 9- 11 Point A – Bullish Signal Point B – Bearish Signal 9- 13 Relative Strength • A simple relative strength ratio could be constructed as ΔPi / ΔIndex _ • 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... relative strength can be assumed to persist over time, then this would be a signal to buy it 9- 14 A Warning About Identifying Trends 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? 9- 15 9- 16 . Chapter 9 Behavioral Finance and Technical Analysis 9. 1 The Behavioral Critique 9- 2 Behavioralism bias Motivation - Stock prices in the 199 0s did not appear to match. the behavioralist ideas in investments comes from one specific time period, the late 199 0s. • The behavioral literature is very weak at providing solutions to these problems. 9- 8 9. 2. Technical. weak at providing solutions to these problems. 9- 8 9. 2. Technical Analysis and Behavioral Finance Attempts to exploit recurring and predictable patterns in stock prices to gene rate superior investment