McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Behavioral Finance and Technical Analysis Chapter 9

9-2 Behavioral Finance Argues that rational financial theories ignore how people actually make decisions Behavioral Finance: emphasizes the potential implications of psychological factors  Anomalies result from irrationalities Criticism of Behavioral Finance  Existence of irrational investors is not sufficient to render capital markets inefficient  Rational investors should be able to correct prices

9-3 Where are the Arbitragers? If arbitragers can exploit these behavioral mispricing then biases shouldn’t matter However, the ability to arbitrage maybe limited in the market:  Model risk: You are betting that you have a better estimate than the entire market BIG RISK  Fundamental risk: Mkt may take longer to correct mispricing than the investor can wait Keynes “Markets can remain irrational longer than you can remain solvent”

9-4 Arbitrage Limits: Example 1 “Siamese twin” companies  Royal Dutch and Shell merged in 1907 One company with two shares: Royal (60% of profits) Shell (40% of profits) →Since Royal get 1.5 times the cash as Shell, Royal should sell for 1.5 times Shell Royal sold for less than Shell Equity carve-outs  3Com split off 5% of Palm, with 3Com shareholders get 1.5 shares of Palm 3Com share price fell below 1.5 of Palm

9-5 Arbitrage Limits: Example 2 Equity carve-outs  3Com split off 5% of Palm, 3Com shareholders receive 1.5 shares of Palm →3Com shares should be worth 1.5 the price of Palm plus the value of 3Com  3Com share price fell below 1.5 of Palm

9-6 People Have Issues Forecasting errors  People overvalue recent experience when forecasting Compared to prior belief Conservatism bias  People are reluctant to change there beliefs when things change Overconfidence  People overestimate their ability, or the accuracy of their predictions

9-7 People Have More Issues Representativeness  People assume that most people think/feel the same way they do Everyone is like me Sample size neglect  Believe small sample is representative of population Infer patterns too quickly

9-8 Behavioral Biases Framing  Decisions affected by how opportunities are posed A 30% chance to win v a 70% chance to loss Mental accounting  Form of framing; people segregate certain decisions, or accounts 1 risky account for vacation saving & 1 safe for college Disposition effect  People hold losses and sell winner

9-9 Behavioral Biases: Continued Regret avoidance  People blame themselves more for unconventional decision than conventional decision No one gets fired for buying IBM Loss Aversion (Prospect theory)  People view gains and losses differently $1,000 loss has a large emotional impact than a $1,000 gain Fear of Regret  Avoiding new information

9-10 Examples of “Irrational Exuberance” Japanese Real Estate Bubble  1 square mile was worth all of California Dot Com Bubble  Went from basing valuation on earnings (or profits) to view and clicks Housing Bubble  Everyone gets a loan

9-11 Technical Analysts Irrationality and behavioral biases can move prices away from fundamentals This can potentially lead to exploitable recurring patterns in the market Technical Analysts are generally looking for momentum

9-12 Detecting Momentum Moving Average: Average price over a given interval, interval updated over time Attempts to identify underlying price directions  Looking for trends Most general momentum signal:  Moving over you 52 week average is a bullish signal

Day Moving Average for Intel Bullish Bearish

Day Moving Average Example Day Price Ave

Day Moving Average Example Day Price Ave

9-16 More Chartist Terminology Breadth  Extent to which broad market index movements affect individual stock prices Relative Strength  Recent performance of given stock/industry compared to that of broad market index

9-17 Sentiment Indicators Trin statistic  Ratio of average volume in declining issues to average volume in advancing issues Confidence index  Ratio of top-rated corporate bond yield to intermediate- grade bond yield Short interest  Total number of shares currently short-sold in market Put/call ratio  Ratio of put options to call options outstanding on stock

9-18 A Warning about Technical Analysis People perceive patterns where none exist  Constellations Data mining generates apparent patterns within limited data sets When evaluating rules, ask whether rule would be reasonable before looking at data