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 corresponding findings Identify reasons why technical analysis may be profitable Discuss the consistence between the technical analysis and the behavioral finance Introduce several classic technical analysis methods 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 potential implications of psychological factors affecting investor behavior The irrationalities fall into two categories:
Information Processing Problems: Investors do not always process information correctly Behavioral Biases: Investors often make inconsistent or suboptimal decisions

Information Processing

Forecasting errors (Memory bias)

Overconfidenc e

Conservatism

Representativ es

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 firms future earning too high stock price and P/E becomes relatively high , so high P/E stocks tend to perform poor when investors recognize and correct their errors

INFORMATION PROCESSING PROBLEMS

Overconfidence

People tend to overestimate the precision of their beliefs or forecasts, i.e., they tend to overestimate their 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

INFORMATION PROCESSING PROBLEMS

Conservatism

A conservatism bias means that investors are too slow (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, reflect news gradually

INFORMATION PROCESSING PROBLEMS

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 future performance, they will invest more money in the firm, exaggerating the price of stock The forecasting errors (memory bias) can be viewed as 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-makers 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 fun with Investors segregate funds into mental accounts (e.g., dividends and capital gains), maintain a set of separate mental accounts, and do not combine outcomes; a loss in one account is treated separately from a loss in another account

BEHAVIORAL BIASES Regret avoidance

Regret Prospect of regret generates avoidance behavior Disposition effect: investors try to avoid regret by selling stocks that have gone down in value, rush to sell 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 should be retained until it returns to its original cost. Conversely, I prefer to take quick profits on successful investments 2.Ill predict the purchase of investments, including derivatives securities periodicially. These aggressive investments result from personal research and may not prove consistent with my investment policy. I have not kept records on the performance of similar past investment but I have had some big winners 3. Income needs should be met entirely through interest income and cash dividends. All equity securities held should pay cash dividends.

BEHAVIORAL BIASES
Prospect

theory

We have an irrational tendency to be less willing to gamble with profits than with losses. This means selling quickly when we earn profits but not selling if we 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 face different kinds of gambles
1. The results show that what affects people's decisions is not their wealth level after the gamble, but the amount of gains or losses from the gamble 2. 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 a concave utility function (in Diagram A) In Prospect Theory, people are risk averse (thus with concave utility function) 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 60/40 basis (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 * palms price. The day before the palm IPO, the price of 3com closed at $104.13 per share. after the first day of trading, Palm closed at $95.06 per share (implying that the price of 3com 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 first day of trading => mispricing Arbitrage limited by the inability of investors to sell palm short.

CLOSED-END FUNDS

- May sell at premium or discount to NAV => violation of the law of one price. - Can also be explained by rational return expectations.

BUBBLES AND BEHAVIORAL ECONOMICS

From

1995 to 2001, the Nasdaq index increased by a factor of more than 6

This dot-com boom development could be explained by some irrationalities in the behavioral finance
Investors were increasingly confident of their forecasts and apparently extrapolate short-term patterns into the distant future (memory or representativeness bias) The overconfidence arises from the situation in which investors always earn huge capital gains regardless of what to buy and when to buy The interaction of these two biases can explain the bubble from 1995 to 2001

CRITIQUES FOR THE BEHAVIORAL FINANCE

Try

to explain anomalies but does not give guidance of how to exploit these irrationalities
each anomaly by some subjective combination of irrationalities from the list of behavioral biases. There is not a unified behavioral theory to explain a range of anomalies is possible to have conflicts between different theories, e.g., overreaction (from memory or representativeness bias) vs. underreaction (form conservatism bias)

Explain

It

9.2 TECHNICAL ANALYSIS AND BEHAVIORAL FINANCE

TECHNICAL ANALYSIS AND BEHAVIORAL FINANCE

Consistence

between the technical analysis and behavioral 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 technical analysts 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 behavioral finance believe that market fundamentals could be affected by irrational or behavioral factors (labeled psychological variables)

SOME TECHNICAL ANALYSIS METHOD

Dow

theory

It is the ancestor of trend analysis or technical analysis, created by Charles Dow, the founder and first editor of the Wall Street Journal, and cofounder 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 primary trend, these deviations are eliminated via corrections (when prices come back to trend value) Minor trend (swing): daily fluctuations which are with little importance in the trend analysis of the Dow theory

DEFINITION OF CORRECTIONS
Optimistic attitude of investors in anticipating gain

More investors buy into trend, prices increase

The price is high enough

The prices decrease

Buying process become slower and some investors sell the stock to protect their gains

Correction is a decrease in price, following a short-term increase

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 low is higher (lower) than the previous market low (E vs. C vs. A)

SOME TECHNICAL ANALYSIS METHOD

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 the point and figure chart (see the figure on the next slide) It simply traces significant upward or downward movements in stock prices without regard to their timing
Different from other technical analysis, this chart has no time dimension Instead, the aim of this chart is to filter out the noise (unimportant price movement) and focus on finding the main direction of the price trend

TABLE 9.1 STOCK PRICE HISTORY FIGURE 9.5 POINT AND FIGURE CHART

Support

Resistance

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

FIGURE 9.6 POINT AND FIGURE CHART FOR DJIA IN 1988

Buy Signal

Sell Signal

An congestion area is a horizontal band created by several price reversals, i.e., consisting of alternate columns of Xs and Os, and the upper and lower bounds for an congestion area correspond to the resistance and support levels When the stock price penetrates the resistance level from below, it means the market considers about the prospect of the stock is significantly better than that in the previous congestion period and thus a buy signal is generated.

SOME TECHNICAL ANALYSIS METHOD

Moving averages For each day, the

moving average of a specified period of time, e.g., 4 weeks, is recomputed by dropping the oldest observation and adding the latest By definition, the long-term moving average is a more smooth series than the short-term moving average When the short-term moving average crosses the longterm moving average, a trading signal occurs
Bullish (bearish) signals occur when the short-term upward moving average penetrates the long-term upward moving average from below (above) This is because when the recent performance is significantly superior (inferior) to the past performance in a longer period, it is expected that this time point is the beginning of a rising (falling) trend

FIGURE 9.7 SHARE PRICE AND 50-DAY MOVING AVERAGE FOR INTEL
Perfect selling point Bullish signal Bearish signal

Perfect purchasing point

The curve in black represents the daily share prices, which can be viewed as the shortest-term moving average, and the line in brown represents the 50day moving average In this case, both signals provide good forecast about the future movement although they cannot identify the perfect selling and purchasing time points

SOME TECHNICAL ANALYSIS METHOD Breadth

The extent to which the market trend is reflected widely in movements of individual stocks Breadth is measured as the difference between the number of advancing stocks and declining stocks If the advances outnumber declines by a wide margin, then the market is viewed as being stronger because the upward rally is widespread (see the next slide)

TABLE 9.2 BREADTH

The direction of the cumulated breadth series is used to discern market 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 to gauge market trends

SOME TECHNICAL ANALYSIS METHOD Relative strength

Defined as the ratio of prices of an individual stock over the level of an industry index A rising (falling) ratio implies security has outperformed (underperfomed) the particular industry average and generates a signal to buy (sell) (making profit if the relative strength can persist over time) Buy relatively strong and short relatively weak stocks in the same industry: the market and industry risks can be eliminated and earn purely the difference between the performance of these two stocks

E.g., buy shares of TSMC and short shares of UMC

SENTIMENT INDICATORS

SENTIMENT INDICATORS: TRIN

STATISTIC

Volume declining/Number declining Trin = 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

Average Yield on 10 top - rated Corporate Bonds Average Yield on 10 intermedia te grade Corporate Bonds

- This ratio is always smaller than 1 because higher rated bonds will offer lower promised yields to maturity

- Closer to 100% => investors should be bullish

- Away from 100% => investors should be bearish

SENTIMENT INDICATORS: SHORT

INTEREST - Short interest total number of shares that are soldshort 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 to outstanding call options - Put options do well in falling markets. Call options do well in rising market =>Rising ratio : bearish Falling ratio: bullish
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