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Fin2802:

Fin2802: Investments
Investments

Spring,
Spring, 2010
2010
Dragon
Dragon Tang
Tang

Lectures 11&12
Behavioral Finance and Technical Analysis
February 23&25, 2010
Readings: Chapter 12
Practice Problem Sets: 1,2,4,10, 11
Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Where
Where Are
Are We?
We?
How?

Securities
Markets
Institutions
Trading
Delegated investment

Why?

Market efficiency
Historical performance

What?

Stock
Bond
Evaluation
International
Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Where
Where Are
Are We?
We?
How?

Securities
Markets
Institutions
Trading
Delegated investment

Why?

Market efficiency
Historical performance

What?

Stock
Bond
Evaluation
International

So What?

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Behavioral
Behavioral Finance
Finance and
and Technical
Technical Analysis
Analysis
Objectives:
1. Understand the principles of behavioral finance.
2. Identify reasons why technical analysis may be profitable.
3. Use the Dow theory to identify situations that technicians
would characterize as buy or sell opportunities.
4. Use indicators such as volume, breadth, short interest, or
confidence indexes to measure the "technical condition" of
the market.
5. Explain why most of technical analysis is at odds with an
efficiently functioning stock market.
Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Behavioral
Behavioral Finance
Finance
Traditional theories (e.g., CAPM) assume rational investors
Systematic behavioral biases (anomalies) have been
observed
Behavioral finance tries to incorporate some aspect of
investors behavior and explain those anomalies using
psychological principles
It is a developing and important area
Companies exploiting behavioral biases:
Lakonishok, Shleifer and Vishny (LSV)
Dimensional Fund Advisors (DFA)
Fuller and Thaler Asset Management
Case-Shiller-Weiss
Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Individual
Individual Behavior
Behavior
Cooperation and Altruism
Bidding and the Winners Curse
Endowment Effect, Status Quo Bias and Loss
Aversion
Mental Accounts

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Figure
Figure12-1
12-1 Loss
LossAversion
Aversion Preference
Preference Function
Function

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Asset
Asset Returns
Returns and
and Behavioral
Behavioral
Explanations
Explanations
Calendar Effects
Cash Dividends
Overreaction and Mean Reversion
Controversial explanations from behavioral finance
Closed-end fund discount puzzle
Excess volatility in stock prices
Loss aversion

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Limits
Limits to
to Arbitrage
Arbitrage
Fundamental Risk
Implementation Costs
Model Risk
Siamese Twin Companies
Equity Carve-outs
Closed-End Funds

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Figure
Figure12.2
12.2Pricing
Pricingof
ofRoyal
RoyalDutch
DutchRelative
Relativeto
toShell
Shell(Deviation
(Deviationfrom
fromParity)
Parity)

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

10

Technical
Technical Analysis
Analysis

Attempts to exploit stock price patterns for


profit.
Assumes prices adjust slowly to their true
equilibrium values

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

11

Technical
Technical Analysis
Analysis and
and EMH
EMH
Technical analysis clashes with the EMH
hypothesis.
EMH predicts rapid adjustment of prices
with the onset of new information.
Evidence for the success of technical
analysis is poor.

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

12

Technical
Technical Analysis
Analysis Tool-kit
Tool-kit
Charting: The analysis of charts of stock price
and volume with the hope of finding patterns to
exploit in the markets.
The Dow Theory
Point and Figure Chart
Elliott Wave Theory

Technical Indicators
Sentiment Indicators: Market Volume (Trin Statistic); Oddlot Trading; Confidence Index; Put/Call Ratio; Mutual Fund
Cash Position
Flow of Funds: Short Interest; Credit balances in brokerage
accounts
Market Structure: Moving Averages; Breadth; Relative
Strength;
Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

13

Charting:
Charting: The
The Dow
Dow Theory
Theory
The Dow Theory:
Uses price and volume trends to predict
stock prices.
Identifies primary, secondary, and tertiary
trends.
Predicts support and resistance price levels.

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

14

Figure
Figure 19-2
19-2 Dow
Dow Theory
Theory Trends
Trends

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

15

Figure
Figure19-3
19-3 Dow
DowJones
Jones Industrial
IndustrialAverages
Averages in
in 1988
1988

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

16

Charting:
Charting: Elliott
Elliott Wave
Wave Theory
Theory
Elliott Wave Theory:
Stock prices can be described by a set of
wave patterns
Long-term and short-term wave cycles are
superimposed on each other
By interpreting the cycles, one can predict
broad movements

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

17

Figure
Figure19-4
19-4 Point
Point and
and Figure
FigureChart
Chart for
forTable
Table19-2
19-2

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

18

Table
Table 19-2
19-2 Stock
Stock Price
Price History
History

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

19

Figure
Figure19-5
19-5 Point
Point and
and Figure
FigureChart
Chart for
forAtlantic
AtlanticRichfield
Richfield

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

20

Figure
Figure 19-6
19-6 Candlestick
Candlestick Chart
Chart

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

21

Charting:
Charting: A
AWarning
Warning
A Warning:
Seeing patterns that dont exists
After the fact, one can always find patterns
and trading rules that would have generated
enormous profits
What has worked in the past may not work
in the future.

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

22

Figure
Figure19-7
19-7Actual
Actual and
and Simulated
Simulated Stock
StockPrices
Prices for
for52
52Weeks
Weeks

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

23

Figure
Figure 19-8
19-8 Actual
Actual and
and Simulated
Simulated Changes
Changes
in
in Weekly
Weekly Stock
Stock Prices
Prices for
for 52
52 Weeks
Weeks

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

24

Technical
Technical Indicators:
Indicators: Sentiment
Sentiment Indicators
Indicators
Market Volume: Higher volume gives strong confirmation
to price trend.

Volume declining/Number declining


Trin
Volume advancing/Number advancing
Trin>1: Bear Market; Trin<1: Bull Market

Odd-lot Trading (less than 100 shares): Small investors


tend to miss key market turning points.

- Odd-lot buying heavy investors should be bearish.


- Odd-lot selling heavyinvestors should be bullish.

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

25

Technical
Technical Indicators:
Indicators: Sentiment
Sentiment Indicators
Indicators
Confidence Index:

Average Yield on 10 top - rated Corporate Bonds


Average Yield on 10 intermediate grade Corporate Bonds
Closer to 100% investors should be bullish
Away from 100% investors should be bearish.

Put/Call Ratio: Ratio normally hovers around 65%.


Rising ratio investors should be bearish?
Rising ratio investors should be bullish?

Mutual Fund Cash Positions


More cash bearish?

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

26

Technical
Technical Indicators:
Indicators: Flows
Flows of
of Funds
Funds
Short Interest: The volume of short selling
High volume investors should be bearish.
or

Low volumeinvestors should be bullish.


High volume investors should be bullish.
Low volumeinvestors should be bearish.

Credit Balances in Brokerage Accounts


High balance bullish

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

27

Market
Market Structure
Structure Indicators
Indicators

Moving Averages
Average price over some historical period (5 weeks or 200
days)
When current price crosses the average a trading signal
occurs
Bullish signal when the current price rises above the
moving average
Bearish sign when the current price falls below the
moving average

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

28

Technical
Technical Indicators:
Indicators: Market
Market Structure
Structure
Moving Average: Average over a given interval,
continuously updated.
Price
And
M.A.

Price

Bullish Signal

Bearish Signal

Moving Average
Averaging interval

Fin 2802, Spring 10 - Tang

Time

Chapter 12: Behavioral Finance and Technical Analysis

29

Figure
Figure19-10
19-10 Moving
MovingAverage
Average for
forMicrosoft
Microsoft

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

30

Figure
Figure 19-11
19-11 Moving
Moving Averages
Averages

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

31

Technical
Technical Indicators:
Indicators: Market
Market Structure
Structure
Breadth: The spread between the number of advancing
issues and the number of declining issues.

Advances > declines bullish


Advances < declines bearish
Relative Strength:
Price of a Stock
Price Index for the Industry

or

Persistent Rising ratio bullish.


Persistent Falling ratio bearish.
Fin 2802, Spring 10 - Tang

Price Index of an Industry


Market Price Index
Momentum
Strategies

Chapter 12: Behavioral Finance and Technical Analysis

32

Figure
Figure19-12
19-12 Cumulative
Cumulative Difference
Difference in
in Returns
Returns
of
of Previously
Previously Best
Best and
andWorst
Worst Ranking
Ranking Stocks
Stocks
in
in Subsequent
Subsequent Months
Months

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

33

Value
Value Line
Line System
System
Widely followed with some evidence of superior
performance
Value Line System is predominately a technical
system
Earnings momentum
Relative stock prices
Ratios of moving averages

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

34

Figure
Figure19-13
19-13 Record
Record of
of Value
Value Line
Line Ranking
Ranking for
forTimeliness
Timeliness
(without
(without adjustment
adjustment for
forchange
change in
in rankings)
rankings) 1965-1990
1965-1990

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

35

Value
Value Line
Line System
System
Paper vs actual performance indicates that the
system is difficult to implement
Value Line Fund has not shown superior
performance
High turnover costs are associated with the strategy

Evidence shows prices react quickly to reported


ranking changes

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

36

Technical
Technical Analysis
Analysis and
and Market
Market Efficiency
Efficiency

Reaction time and length of trends


EMH new information is quickly
reflected in prices.
Technical analysis long-lived trends
play out slowly and predictably.
A useful technical rule would be
invalidated once the mass of traders
attempt to exploit it (self-destructing
Patterns)
Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

37

A
ANew
New View
View of
of Technical
Technical Analysis
Analysis
EMH: Public information is available to all;
Price reflect all available information
Study by Brown and Jennings (RFS, 1989):
Many investors have private information
Sequence of past price can be useful in the
inference of information held by other traders
Prices reveal as well as reflect information
Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

38

Summary
Summary
Principles of behavioral finance, individual behavior,
behavioral explanations
Technical analysis is the search for recurring patterns in stock
prices; Technical analysis assumes prices adjust slowly
Charting: The Dow Theory
Point and Figure Charts
Elliott Wave Theory
Technical Indicators: Sentiment Indicators
Flow of Funds
Market Structure
New theories of information dissemination

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

39