Chapter Twelve

Behavioral Finance
and Technical Analysis

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 Chapter Overview
• EMH makes two important predictions
1. Security prices property reflect whatever
information is available to investors
2. Active traders will find it difficult to outperform
passive strategies such as holding market indexes
• Tests of market efficiency have focused on the
performance of active trading strategies
• Behavioral finance assumes investors are not
rational
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 Behavioral Finance

Conventional Finance Behavioral Finance

• Prices are correct and • What if investors don’t
equal to intrinsic value behave rationally?
• Resources are • Arbitrageurs are
allocated efficiently limited and therefore
• Consistent with EMH insufficient to force
prices to match
intrinsic value

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 The Behavioral Critique
• Two broad categories of irrationalities
1. Investors do not always process information
correctly and therefore infer incorrect
probability distributions of future returns
2. Even when given a probability distribution of
returns, investors may make inconsistent or
suboptimal decisions

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 Information Processing
• Limited attention, underreaction, and overreaction
• Reliance on heuristics due to limited time/attention
• Overconfidence
• People tent to overestimate the precision of their beliefs
or forecasts, and they tend to overestimate their abilities
• Extrapolation and pattern recognition
• Representativeness bias
• Individuals are adept at discerning patterns, even
perceiving patterns that may be illusory
• Overly prone to believe these patterns are likely to persist

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 Behavioral Biases
• Framing
• Decisions affected by how choices are described, such as whether
uncertainty is posed as potential gains from a low baseline levels, or
as losses from a higher baseline value
• Mental accounting
• Specific form of framing in which people segregate certain decisions
• Regret avoidance
• Individuals who make decisions that turn out badly have more regret
when that decision was more unconventional
• Affect and feelings
• Investors tend to choose stocks with high affect, driving up prices
while simultaneously driving down returns

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 Behavioral Biases: Prospect Theory
• Conventional view: Higher wealth provides higher
utility, but at a diminishing rate
• Behavioral view: Utility depends on changes in
wealth from current levels, not the level of wealth

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 Limits to Arbitrage
(1 of 2)

• Behavioral biases would not matter if rational

arbitrageurs could fully exploit the mistakes of
behavioral investors
• Fundamental risk
• “Markets can remain irrational longer than you
can remain solvent” -- Keynes
• Intrinsic value and market value may take too long
to converge

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 Limits to Arbitrage
(2 of 2)

• Implementation Costs
• Transactions costs and restrictions on short-selling
can limit arbitrage activity

• Model Risk
• What if you have a bad model and the market
value actually is correct?

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 Limits to Arbitrage and the
Law of One Price (1 of 2)
• “Siamese Twin” Companies
• Royal Dutch should sell for 1.5 times Shell
• Deviated from parity ratio for extended periods
• Example of fundamental risk

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 Limits to Arbitrage and the
Law of One Price (2 of 2)
• Equity Carve-Outs
• Examples: 3Com and Palm
• Arbitrage limited by availability of shares for
shorting

• Closed-End Funds
• May sell at premium or discount to NAV
• Can also be explained by rational return
expectations
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 Bubbles and Behavioral Economics
(1 of 2)

• Bubbles are easier to spot after they end

• Dot-com bubble
• 6-year period beginning in 1995
• Overconfidence and representativeness biases

• Housing bubble
• Set off worst financial crisis in 75 years

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 Bubbles and Behavioral Economics
(2 of 2)

• Rational explanation for • S&P 500 is worth

stock market bubble $12,883 million if
using the dividend dividend growth rate is
discount model: 8% (close to actual
value in 2000)
• S&P 500 is worth
D1
PV0  $8,589 million if
kg dividend growth rate is
7.4% (close to actual
value in 2002)

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 Technical Analysis and
Behavioral Finance
• Technical analysis attempts to exploit
recurring and predictable patterns in stock
prices to generate superior investment
performance
• Prices adjust gradually to a new equilibrium
• Market values and intrinsic values converge slowly
• Disposition effect
• Demand for shares depends on price history
• Can lead to momentum in stock prices
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 Trends and Corrections
• Momentum and moving averages
• The moving average is the average price over a
given time interval, where the interval updates as
time passes
• Bullish signal signifies a shift from a falling trend to
a rising trend
• Bearish signal signifies price series crossing from
above the moving average to below it,
representative of the beginning of a downward
trend in stock prices
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Share Price and 50-Day Moving
Average for INTC

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Technical Analysis: Relative Strength
• Relative strength
• Measures the extent to which a security has
outperformed or underperformed either the
market as a whole or its particular industry
• Calculated as the ratio of the price of the security to a
price index for the industry
• Strength of industry relative to the whole market
• Computed by tracking the ratio of the industry price
index to the market price index

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 Technical Analysis: Breadth
• Breadth
• Measure of the extent to
which movement in a
market index is reflected
widely in the price
movements of all the
stocks in the market
• Most common measure
is the spread between
the number of stocks
that advance and decline
in price
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 Technical Analysis:
Sentiment Indicators (1 of 3)
• Trin statistic
Volume declining
Number declining
Trin =
Volume advancing
Number advancing

• Ratios above 1.0 are bearish

• Rising volume in a rising market should not
necessarily indicate a larger imbalance of buyers
versus sellers
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 Technical Analysis:
Sentiment Indicators (2 of 3)
• Confidence index
• Ratio of the average yield on 10 top-rated
corporate bonds divided by the average yield on
10 intermediate-grade corporate bonds
• Ratio will always be below 1
• Higher values are bullish signals

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 Technical Analysis:
Sentiment Indicators (3 of 3)
• Short interest
• Total number of shares of stock current sold short
• Increased short interest reflects negative sentiment
and is a warning sign concerning the stock’s
prospects
• Put/call ratio
• Ratio of outstanding put options to outstanding call
options
• Rising ratio is taken as a sign of broad investor
pessimism and a coming market decline
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 Technical Analysis: A Warning
• It is possible to perceive patterns that really
don’t exist
• Figure 12.6A is based on the real data
• The graph in panel B was generated using
“returns” created by a random-number generator
• Figure 12.7 shows obvious randomness in the
weekly price changes behind the two panels in
Figure 12.6

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Actual and Simulated Levels for
Stock Market Prices of 52 Weeks

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Actual and Simulated Changes
in Stock Prices for 52 Weeks

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