E.  Behavioral Finance and Technical Analysis

1.  Behavioral finance

• Emphasize potential implications of psychological factors affecting investor behavior

• Conventional financial theory ignores how real people make decisions

• People may act irrationally

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a.  Irrationalities

(1) Information processing

• Investors misestimate true probabilities of possible events or rates of return

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(a)  Forecasting errors

• Too much weight given to recent experiences (memory bias)

• Forecasts tend to be too extreme

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(b) Overconfidence

• Tendency to overestimate precision of forecasts and beliefs

Ex. - Active vs. passive management, men vs. women

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(c) Conservatism

• Investors are too slow in updating beliefs in response to new evidence

• Initial underreaction to news about a company

• Prices reflect new information gradually

• Leads to momentum

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(d) Sample size neglect and representativeness

• Patterns inferred based on small samples

• Trends extrapolated too far into the future

• Leads to overreaction

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(2) Behavioral biases

• People make less-than-fully-rational decisions, even with perfect information

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(a) Framing

• How a choice is framed can affect decisions

• Individuals risk averse in terms of gain, risk seeking in terms of losses

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(b) Mental accounting

• Investors segregate certain decisions

Ex. - Dividend paying stocks vs. capital gains, selling gains vs. losses

• House money effect - gamblers more willing to accept new bets when they are ahead

• More tolerant of risk => lower discount rate => higher prices

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(c) Regret avoidance

• Investors have more regret when decisions are more unconventional

• Become more risk averse => higher discount rate => premium for value stocks

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(d)  Prospect theory

• Investor utility depends on gains and losses from starting position, rather than level of wealth

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b.  Limits to arbitrage

• Behavioral biases wouldn't matter if arbitrageurs could fully exploit mistakes of behavioral investors

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(1) Fundamental risk

• May take time to reach intrinsic value

• Situation could get worse before it gets better

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(2) Implementation costs

• Particularly difficult to exploit overpriced stocks

• High costs to short sell a security

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(3)  Model risk

• Model may be faulty and stock price is correct

• Model may be correct, but exploiting mispricing is still risky

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2. Technical analysis

• Attempt to exploit recurring and predictable patterns in stock prices

a.  Trends and corrections

• Are there trends in market prices?

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(1)  Momentum and moving averages

• Compare current price with a moving average of previous prices

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• Waves (Elliott, Kondratieff)

• Both long-term and short-term waves in stock prices

(2)  Point and figure charts

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• Buy signal when previous high is penetrated, sell signal when previous low is penetrated

• Congestion area - horizontal band created by several price reversals

(3) Breadth

• Compare number of advancing stocks with declining stocks

• Use moving average of cumulative breadth

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(4)  Relative strength

• Compare individual security to industry as a whole

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b.  Sentiment indicators

• Measures general optimism or pessimism among investors

(1) Trin

• Based on market volume

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(2) Confidence Index

• Published by Barron's

• Assumes actions of bond traders reveal trends about stock market

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• If bond traders optimistic about economy, premium on lower quality debt reduced, raising the index

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(3)  Short interest

• Total number of shares currently sold short in the market

- Bullish - shares have to be repurchased in the future

- Bearish - short sellers are more sophisticated investors

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(4)  Put/call ratio

• Call - right to buy a stock at a given price by a given date

• Put - right to sell a stock at a given price by a given date

• Buy puts when pessimistic, buy calls when optimistic

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- Bearish - sentiment among investors is negative

- Bullish - negative sentiment means stock prices are depressed

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c.  Charting

• Look for patterns, support and resistance levels

• Technical analysis