Lecture 7

MOD004491 Corporate FinanceBehavioural Finance and Technical Analysis
MOD004491 Corporate Finance

Behavioural Finance and Technical Analysis
Anglia Ruskin University

Dr Handy Tan
handy.tan@anglia.ac.uk
20 March 2017
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Highlights
1 Understand how behavioural finance came about

2 Understand and apply the principles of technical analysis (TA)
3 Understand the various techniques in TA in identifying buy and sell opportunities
Reading: BKM chapter 9
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Anomalies in the Efficient Market Hypothesis (EMH)
Recall when we talked about the Efficient Market Hypothesis (EMH), academics in
the 1960s and early 70s traditionally support EMH whilst most practitioners have not.
In a sense, theory ignores some aspects of investors behaviour.
This is changing with the development of behavioural finance. It stresses the irra-
tionality of investors in terms of information processing and behavioural biases.
Began with the studies that identified anomalies.
Slowly, during the 1980s and 1990s explanations for these anomalies were suggested
based on theories taken from psychology, especially the Judgement and Decision mak-
ing literature (e.g. Kahneman and Tversky).
Early pioneers included: Robert Shiller (Irrational Exuberance), Richard Thaler, Hersh
Shefrin (Beyond Greed and Fear), Meir Statman, Andrei Shleifer...
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A brief introduction to behavioural finance
Underlying the EMH is the idea that there may be irrational traders out there, but
there are enough smart traders, who tend to have the most money, to dominate
central role of arbitrage (getting something for nothing).
Two central assumptions of behavioural finance:
(i) It is not riskless;
(ii) There can be institutional restrictions.
Individuals are subject to cognitive biases and heuristics (trial and error).
(i) Cognitive biases: people make predictable mistakes when assessing information (e.g.
Thinking, Fast and Slow by Daniel Kahneman);
(ii) Heuristics are rules of thumb for decision making.
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Arbitrage can be risky (historical example)!
Convergence arbitrage short and long positions in instruments that must converge
at some point.
Royal Dutch and Shell merged in 1907. They continue to trade on different stock
markets (Royal Dutch mainly in the US and NL, Shell mainly in London).
All cash flows, adjusting for tax, etc., are split 60:40.
This implies that Royal Dutch should, at all times, be 1.5 times the value of Shell.
Divergence from this ratio triggers arbitrage trades (this was one of LTCMs trades!)
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Royal Dutch and Shell
Fig. 1. Royal Dutch and Shell
Source: Lamont and Thaler. Anomalies: the law of one price in financial markets. Journal of Economic
Perspectives. 17(4). pp. 191-202.
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Another example...
In the 1990s: sustained bull market led by Technology, Media and Telecommunications
(TMT) stocks.
Price-to-Earnings (PE) ratios doubled from their historical levels.
Had fundamental changed so much to justify this? No!
Behavioural Finance (BF) would view this example as overreaction fuelled by irrational
exuberance.
Evidence suggests that firms adding .com to the end of their names in the 1990s
enjoyed a meaningful price increase: does this sound rational?
NB: irrational exuberance was first used by the then Federal Reserve Chairman, Alan Greenspan, in a speech
with the American Enterprise Institute during the dot.com bubble in the 1990s.
Also the title of Robert J. Shillers book, Irrational Exuberance.
Cf. Cooper, Michael J, Dimitrov, Orlin and Rau, P. Raghavendra. A Rose.com by any other name. December
2001. The Journal of Finance 56(6). pp. 2371-2388.
Cf. Vise, David A. The Google Story. 2008. Pan Publisher.
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A bit of psychology
The idea of behavioural finance came from the studies in psychology, notably the works
of Daniel Kahneman and Amos Tversky in developing Prospect Theory.
Prospect Theory studies how people form decisions about prospects (here prospects
refer to gambling or uncertainty). To main ideas under the theory are: The value
function (shown below) and the weighting function.
The value function shows that people tend to react more pronounced to little losses
than they do with little gains (concave down on the gains like diminishing marginal
utility in economics, but concave up with losses).
With the weight function (not shown here), it dictates that people generally assign
probability zero for things that they know for sure will not happen and one if it will
happen. Anywhere else in between zero and one, people tend to exaggerate downwards
(all the way to zero) or upwards (all the way to one). 8 / 39
A very brief introduction to cognitive biases
Overconfidence:
(i) Overconfident investors underestimate risk (by investing in riskier assets with little
diversification) (put all eggs in one basket).
(ii) Seeing patterns where there are none.
(iii) The gamblers fallacy (for expecting reversal).
(iv) Hot hands effect (for expecting a continuation). This may result in frequent trading
than necessary (higher transaction costs).
Investors tend to make forecasts that are too extreme given the uncertainty of their
information (e.g. PE effect).
Conservatism: investors are too slow (conservative) in updating their beliefs in response
to recent evidence (e.g. momentum in stock market returns calculated, for example,
using returns of the best performing stocks over the past 6 months minus the return
on the worst performing).
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Test of overconfidence
PollEV
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The representativeness and affect heuristic
In his book, Thinking, Fast and Slow, Kahneman offers an anecdote to illustrate affect
heuristic. Talking with an investment officer who explained his decision to invest a
large sum in Ford stock by recounting a recent trip to a car exhibition where he had
been really impressed: boy, do they know how to make a car.
What is wrong with this line of reasoning?
Affect heuristic: making decisions that are guided by liking and disliking.
Note how a hard question was (subconsciously) replaced by an easy question.
Representativeness: can be thought of as similar to stereotyping. A good company is
mistaken for a good investment.
NB: This is also an issue of cognitive dissonance, or the judgemental bias that people tend to make because
they do not want to admit that they are wrong (i.e. forget the evidence).
Festinger, Leon. A Theory of cognitive dissonance. 1957. Stanford University Press.
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The representativeness and affect heuristic (cont...)

Lakonishok, Shleifer & Vishny demonstrate that good companies often do not make a
good investment. NB: They were not the first to identify this representative bias.
Rank companies by sales growth, categorise companies as glamour (or growth stocks)
or value (e.g. value means low PE ratio, high book-to-market ratio or low prices
compared to historic).
Lakonishok, Josef., Shleifer, Andrei., and Vishny, Robert W. Contrarian investment, extrapolation, and risk.
December 1994. The Journal of Finance. 49(5). pp. 1541-1578.
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Technical analysis
Technical analysts are those traders that use trend analysis to uncover trading oppor-
tunities.
They are often called chartists because they make use of charts to seek patterns.
They operate under the assumption that as long as anomalies in asset pricing persist,
technical analysis may be considered a defensible tool to exploit observed inefficient
prices.
Trends in prices can be exploited (i.e. markets are somewhat inefficient).
Technical analysis is essentially a reflection of idea that stock market moves in trends
which are determined by the changing attitudes of investors to a variety of economic,
monetary, political and psychological forces...The art of technical analysis, for it is
an art, is to identify changes in such trends at an early stage and to maintain an
investment posture until a reversal of that trend is indicated (Pring, 1985).
Cf. Pring, Martin J. Technical Analysis Explained: The Successful Investors Guide to Spotting Trends and
Turning Points. 2014. McGraw-Hill Education.
Cf. Edwards, Robert D., and Magee, John. Technical Analysis of Stock Trends. 2013. CRC Press.
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Tools used in technical analysis
Dow Theory
Point and Figure Chart
Moving Averages and Bollinger Bands
Breadth
Relative Strength
Sentiment indicators such as: Trin Statistics, Confidence Index, Short Interest, Credit
Balances in brokerage accounts and Head and Shoulder.
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The Dow Theory
Creator: Charles Henry Dow (1900-1902 time frame).

The Dow Theory is a technique that attempts to discern long and short-term trends
in stock market prices.
It is used to identify long-term trends in stock market prices.
It uses the key indicator Dow Jones Industrial Average (DJIA) to indicate the underlying
trends.
Generally, there are 3 trends affecting the stock prices: primary, secondary (intermedi-
ary) and tertiary (minor) trends.
Primary trend is the long-term movement in prices.
Secondary (intermediary) trends are caused by short-term deviations in prices from the
underlying trend line.
Tertiary or minor trends are daily fluctuations of little importance.
NB: Charles Dow was a journalist, founder and first editor of the Wall Street Journal and co-founder of the Dow
Jones and Company with Edward Jones and Charles Bergstresser.
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Dow theory trends: The three components of the stock price movements
Fig. 2. Dow Trends
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Support and resistance levels in stock prices
The Dow Theory incorporates the notions of support and resistance levels in stock
prices:
(i) A support level is a value below which the market is unlikely to fall.
(ii) A resistance level is a level above which it is difficult to rise.
Support and resistance levels are determined by the recent history in stock prices.
Resistance is equivalent to a supply line: when prices increase, the quantity of sellers
also increases as more investors are willing to sell at these higher prices. When too
much selling occurs, however, prices retreat. When this happens repeatedly near a
specific price level, resistance forms at that price level.
Support is equivalent to a demand line: when prices decrease, the quantity of buyers
increases as more investors are willing to buy at lower prices. When too much buying
occurs, however, prices rise. When this happens repeatedly near a specific price level,
support forms at that price level.
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Dow theory and the EMH
If stock prices were to actually follow any of these patterns, profit opportunities would
result.
The patterns are reasonably straightforward to discern, meaning that future prices can
be extrapolated from current prices.
Problem: Would we be able to recognise patterns as they emerge?
We will see support and resistance charts momentarily...
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Point and figure charts
Point and figure charts do not have a time dimension on the horizontal axis.
The price increases and decreases are recorded irrespective of their time dimension.
Point and figure chartists look for trend and congestion areas.
Identify patterns (or successions) of large increases and decreases in prices.
Graph collections of increases (X) and decreases (O) in prices.
Identify so called penetration points (buy and sell signals).
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Point and figure charts: The data
Fig. 3. Point and figure 20 / 39

Point and figure charts: Buy and sell signals
Sell signals are generated when the stock price penetrates previous lows.
Buy signals occur when previous high prices are penetrated.
A congestion area is a horizontal band of Xs and Os created by several price reversals.
These regions correspond to support and resistance levels.
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Point and figure charts: Buy and sell signals (cont...)
Fig. 4. Point and figure Buy and sell

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Moving average
Average price over some historical period (i.e. a given interval of time, e.g. 5 weeks).
You can then plot these averages (over a fixed interval) forming the moving average.
A 50 day MA means all of the averages calculated using a window of 50 trading days.
When the current price crosses the average, a trading signal occurs:
(i) Bullish signal when the current price rises above the moving average;
(ii) Bearish signal when the current price falls below the moving average.
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1-Year (50,100,200) Simple Moving Averages for Tesco Plc
Fig. 5. (50,100,200) SMAs TSCO
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Moving average and Bollinger Bands
Bollinger bands are nothing more than a variation of MA plot. The difference is that
with BB, in addition to the MA, the chartist also plots the standard deviation of
the moving average.
When the current price crosses these bands, a trading signal occurs:
(i) Bullish signal when the current price rises below the lower bound of the band;
(ii) Bearish signal when the current price falls from the upper bound of the band.
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1-Year 50 Simple Moving Averages for Tesco Plc with 2 standard

deviations
Fig. 6. 50 SMA TSCO with 2 BB
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Breadth
Breadth is the extent to which movements in a broad market indexes are reflected
widely in the movements of individual stock prices.
Most common measure: spread between the number of stocks that advance (advancing
stocks) and decline (declining stocks) in price.
If advances outnumber declines by a wide margin, then the market is viewed as being
stronger.
These breadth numbers are reported daily in the financial press.
Some analysts cumulate breadth data each day.
Cumulative breadth is obtained by adding that days net advances (or declines) to the
previous days total.
The direction of the cumulated series is then used to discern broad market trends.
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Breadth (cont...)
Tab. 1. Breadth and Cumulative Breadth
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Relative strength
It measures the extent to which a security has outperformed or underperformed either

the market as a whole or its particular industry.
It is computed by calculating the ratio of the price of the security to a price index for
the industry.
Similarly, the relative strength of an industry relative to the whole market can be
computed by tracking the ratio of the industry price index to the market index.
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Relative strength (cont...)
Tab. 2. Relative strength
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Sentiment Indicators: Trin statistics (Traders Index)
The Trin Statistics (Arms index) is the ratio of the average volume in declining issues
to the average volume in advancing issues.
Volume declining/number declining
It is given as: TS = .
Volume advancing/number advancing
If the TS > 1, a bearish (pessimistic) signal occurs.
If the TS < 1, a bullish (optimistic) signal occurs.
The Wall Street Journal publishes TS every day.
Lets see what happens today with TS.
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Consumer sentiment index
University of Michigan develops and maintains consumer sentiment index for the US.
It is constructed using surveys sent out on a regular basis (e.g. monthly) to assess
consumers expectations about the future (or near future spending) conditioned on the
current economy.
The index (along with other indexes) is then used to gauge the future outlook of the
market.
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UMich Index of Consumer Sentiment
Fig. 7. Consumer Sentiment

NB: Final results for March 2017 shows CSI of 97.6 up 1.3% from 96.3 in February with +7.3% change in the
year-to-year.
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Short interest
Short interest the number of shares that are sold short.

When short sales are high, a signal occurs.
Two interpretations:
(i) Bearish: short-sellers tend to be larger and more sophisticated investors; increased
short interest reflects bearish sentiment by those investors;
(ii) Bullish: because all short sales must be covered (short-sellers eventually repurchase the
shares), short interest represents latent future demand for the stock.
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Credit balances in brokerage accounts
Investors leave balances in brokerage accounts when they plan to invest in the future.
When levels are high, a bullish sign for the market awaits...
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Head and shoulders (representative heuristics)
Search for patterns in stock market prices is nearly irresistible...unfortunately, it is

possible to perceive patterns that dont really exist.
Take the figure on the left (shown on the next slide): It appears as though the market
presents a classic head and shoulders pattern where the middle hump (the head) is
flanked by two shoulders.
When the price index pierces the right shoulder, it is believed to be heading lower
and it is time to sell your stocks.
The figure on the right also looks like a typical stock market pattern.
Check figure 9.8 (p. 282) in your BKM textbook.
You will see that indeed the weekly price changes behind the two panels in the figure
shown on the next slide are random!!!
Kahneman, Daniel and Tversky, Amos. Judgement and uncertainty: Heuristics and biases. 27 Sept. 1974.
Science. 85(4157). pp. 1124-1131.
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Head and shoulders (cont...)
Fig. 8. Head and shoulders patterns
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Trying to make sense of it all!!!
Most of technical analysis is based on the idea that are totally at odds with EMH.
So, if you believe in EMH, you will dismiss technical analysis as irrelevant.
However, if you believe in behavioural finance, you will recognise that TA has merit,
especially in trying to measure sentiment.
The ultimate choice about which view to support is yours.
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Summary
Understand how behavioural finance came about

Understand and apply the principles of technical analysis (TA)
Understand the various techniques in TA in identifying buy and sell opportunities
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Lecture 7

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MOD004491 Corporate FinanceBehavioural Finance and Technical Analysis

MOD004491 Corporate Finance

Anglia Ruskin University

1 Understand how behavioural finance came about

Anomalies in the Efficient Market Hypothesis (EMH)

A brief introduction to behavioural finance

Arbitrage can be risky (historical example)!

Royal Dutch and Shell

Fig. 1. Royal Dutch and Shell

A very brief introduction to cognitive biases

The representativeness and affect heuristic

The representativeness and affect heuristic (cont...)

Tools used in technical analysis

The Dow Theory

Creator: Charles Henry Dow (1900-1902 time frame).

Fig. 2. Dow Trends

Support and resistance levels in stock prices

Dow theory and the EMH

Point and figure charts

Point and figure charts: The data

Fig. 3. Point and figure 20 / 39

Point and figure charts: Buy and sell signals

Point and figure charts: Buy and sell signals (cont...)

Fig. 4. Point and figure Buy and sell

1-Year (50,100,200) Simple Moving Averages for Tesco Plc

Fig. 5. (50,100,200) SMAs TSCO

Moving average and Bollinger Bands

1-Year 50 Simple Moving Averages for Tesco Plc with 2 standard

Fig. 6. 50 SMA TSCO with 2 BB

Tab. 1. Breadth and Cumulative Breadth

It measures the extent to which a security has outperformed or underperformed either

Relative strength (cont...)

Tab. 2. Relative strength

Sentiment Indicators: Trin statistics (Traders Index)

Consumer sentiment index

UMich Index of Consumer Sentiment

Fig. 7. Consumer Sentiment

Short interest the number of shares that are sold short.

Credit balances in brokerage accounts

Head and shoulders (representative heuristics)

Search for patterns in stock market prices is nearly irresistible...unfortunately, it is

Head and shoulders (cont...)

Fig. 8. Head and shoulders patterns

Trying to make sense of it all!!!

Understand how behavioural finance came about

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