Behavioral Finance and

Technical Analysis

Bodie, Kane, and Marcus

Essentials of Investments
Chapter 9

Prof. Keng-Yu Ho, NTU Finance Fin 2008/Econ 3016 Investments

Behavioral Finance

• Conventional financial theory ignores how real people

make decisions and that people make a difference.
• Behavioral models of financial markets emphasize on
potential implications of psychological factors affecting
investor behavior.
• “Irrationalities” fall into two broad categories...
• Investors do not always process information correctly and
thus infer incorrect probability distributions about future
returns.
• Even given a probability distribution of returns, investors
often make inconsistent or systematically sub-optimal
decisions.

Prof. Keng-Yu Ho, NTU Finance Fin 2008/Econ 3016 Investments

Information Processing

• Limited Attention, Underreaction, and Overreaction

• People have limited time and attention and as a result
may rely on rules of thumb or intuitive decision making
procedures.
• People’s limited analytic processing capacity may also
cause them to overreact to salient or attention-grabbing
news and underreact to less salient news.
• Overconfidence
• People tend to overestimate the precision of their beliefs
or forecasts, and they tend to overestimate their abilities.
• Overconfidence is not only found in financial market
investors but also in high-ranking corporate managers.

Prof. Keng-Yu Ho, NTU Finance Fin 2008/Econ 3016 Investments

Information Processing

• Conservatism
• People are too slow in updating their beliefs in response
to recent evidence. They might initially underreact to
news about a firm, so that prices will fully reflect new
information only gradually.
• Extrapolation and Pattern Recognition
• People are too prone to believe that a small sample is
representative of a broad population and infer patterns
too quickly.

Prof. Keng-Yu Ho, NTU Finance Fin 2008/Econ 3016 Investments

Behavioral Bias: Framing

• Decisions are affected by how choices are posed, for

example, as gains relative to a lower baseline level or
losses relative to a higher baseline level.
• Individuals may act risk averse in terms of gains but risk
seeking in terms of losses.
• A coin toss with a payoff of $50 for tails.
• A gift of $50 that is bundled with a coin toss that
imposes a loss of $50 for heads.
• Which one would you choose?

Prof. Keng-Yu Ho, NTU Finance Fin 2008/Econ 3016 Investments

Behavioral Bias: Mental Accounting
• Mental accounting is a specific form of framing in which
people segregate certain decisions.
• Investors may take a lot of risk with one investment
account but establish a very conservative position with
another.
• Rationally, it might be better to view both accounts as
part of the investor’s overall portfolio.
• Mental accounting can help explain stock price
momentum.
• House money effect: with a “winnings account” in mind,
a gambler thinks that he/she bets with the casino’s
money.
• Investors with a “capital gains account” become more
tolerant to risk and thus further push up stock prices.

Prof. Keng-Yu Ho, NTU Finance Fin 2008/Econ 3016 Investments

Behavioral Bias: Regret Avoidance

• People blame themselves more for unconventional choices

that turn out badly, so they avoid regret by making
conventional decisions.
• Regret avoidance is consistent with both size and
book-to-market effects.
• Small firms are less well-known.
• High book-to-market firms are “out of favor”.
• Those firms requires more “courage” on the part of the
investor, which increases the required rate of return.

Prof. Keng-Yu Ho, NTU Finance Fin 2008/Econ 3016 Investments

Prospect Theory

• Behavioral theory that investor utility depends on gains or

losses from investors’ starting positions, rather than on
their levels of wealth.
• While conventional utility functions imply that investors
may become less risk averse as wealth increases, utility
functions under prospect theory always recenter on
current wealth, thereby ruling out such decrease.
• The convex curvature to the left of the origin induce
investors to be risk seeking when it comes to losses.
• Disposition Effect
• Investors are more likely to sell stocks with gains than
with losses; they are reluctant to realize losses.
• Consistent with prospect theory as well as the behavioral
bias of mental accounting.

Prof. Keng-Yu Ho, NTU Finance Fin 2008/Econ 3016 Investments

Different Utility Functions

Prof. Keng-Yu Ho, NTU Finance Fin 2008/Econ 3016 Investments

Limits to Arbitrage

• Irrationality would not matter for stock pricng if rational

arbitrageurs can fully exploit the mistakes of behavioral
investors.
• Fundamental Risk
• John Maynard Keynes: “Markets can remain irrational
longer than you can remain solvent.”
• Implementation Costs
• Transaction costs and regulatory restrictions to
implement certain investment strategies, such as
short-selling.
• Model Risk
• Using a faulty model to value the security.

Prof. Keng-Yu Ho, NTU Finance Fin 2008/Econ 3016 Investments

Limits to Arbitrage

• 3Com Equity Carve-Outs

• 3Com decided to spin off its Palm division in 1999.
• Sell 5% of its stake in Palm in an IPO.
• Distribute the remaining 95% of shares 6 months later
to 3Com shareholders (1.5 Palm/3Com).
• After the first trading day of Palm, the price of Palm
was $95.06, and the price of 3Com was $81.81. Does it
make sense?
• Is there an arbitrage opportunity? How and can
investors achieve so?

P3Com = 1.5 × PPalm + Residual Value of 3Com

Prof. Keng-Yu Ho, NTU Finance Fin 2008/Econ 3016 Investments

Bubbles and Behavioral Finance

• Recent bubbles in financial markets...

• Dot-com bubble from the late 1990s to the early 2000s.
• Housing price bubble around 2008.
• Bubbles are a lot easier to identify as such once they are
over. While they are going on, it is not as clear that
prices are irrational.
• During the dot-com bubble, many professionals justify the
stock price by the prospect of technological advances.
• Research documents that firms adding “.com” to the end
of their names during such period enjoy significant stock
price increases, which does not sound rational.

Prof. Keng-Yu Ho, NTU Finance Fin 2008/Econ 3016 Investments

Behavioral Critique

• Criticism of behavioral theory on the full rationality in

investor decision making is well taken. However, the
extent to which limited rationality affects asset pricing
remains controversial.
• Investors who are aware of the potential pitfalls in
information processing and behavioral biases should be
better able to avoid such errors.
• Insights of behavioral finance may lead to conclusions
embaraced by efficient market hypothesis.
• Passive strategy that avoids some behavioral minefields
is also supported by advocates of market efficiency.

Prof. Keng-Yu Ho, NTU Finance Fin 2008/Econ 3016 Investments

Technical Analysis and Behavioral Finance

• Behavioral models give support to techniques that clearly

would be useless in efficient markets.
• The disposition effect can lead to momentum in stock
prices even if fundamental values follow a random walk.
• The fact that the demand of “disposition investors” for
a company’s shares depends on the price history of those
shares means that prices close in on fundamental values
only over time.
• Investors who use technical analysis appear to exhibit
behavioral traits, such as overconfidence and excessive
optimism.
• Overconfident investors trade more, inducing an
association between trading volume and stock returns.

Prof. Keng-Yu Ho, NTU Finance Fin 2008/Econ 3016 Investments

End-of-Chapter Exercises

• 2, 3, 4, 6, 7.

Prof. Keng-Yu Ho, NTU Finance Fin 2008/Econ 3016 Investments