1、Behavioral Finance and Technical Analysis,CHAPTER 9,Introduce the behavior finance and corresponding findings Discuss the consistence between the technical analysis and the behavior finance Introduce several classic technical analysis methods,The Goals of Chapter 9,9.1 THE BEHAVIORAL CRITIQUE,Behavi

2、oral Finance,Proponents of the EMH believe that the competition among many professional traders ensures that security prices ought to be correct In other words, if the prices are distorted, some arbitrageurs could take advantage of these opportunities, that should push prices back to their proper le

3、vel However, the behavioral finance argues that in practice, the actions of such arbitrageurs are limited and therefore insufficient to force prices to match its intrinsic value, i.e., the existence of the price distortions or anomalies in the market is common,Behavioral Finance,Behavioral finance t

4、ries to interpret the anomalies as consistent with several “irrationalities” that seem to characterize individuals making complicated decisions The irrationalities fall into two categories: Information Processing Problems: Investors do not always process information correctly (thus infer incorrect p

5、robability distributions about future rates of return) Behavioral Biases: Investors often make inconsistent or suboptimal decisions,Information Processing Problems,Forecasting errors (預(yù)測誤差) People give too much weight to recent experience when making forecasts and tend to make too extreme forecasts

6、(sometime is termed the memory bias) De Bondt and Thaler (1990) employ this notation to explain the P/E ratio effect: recent good (poor) performance investors tend to forecast the firms future earning too high (low) stock price and P/E becomes relatively high (low), so high (low) P/E stocks tend to

7、perform poor (well) when investors recognize their errors Overconfidence (過度自信) People tend to overestimate the precision of their beliefs or forecasts, i.e., they tend to overestimate their abilities,Information Processing Problems,For overconfident investors, Trading volume may be relatively high

8、Adjust their portfolio very frequently Such overconfidence may be responsible for the overly frequent trading and the active investment management for mutual funds It is difficult to become a fund manager, and once people become fund managers, it is very possible that they are too confident of their

9、 investment abilities Conservatism (保守主義) A conservatism bias means that investors are too slow (too conservative) in updating their beliefs in response to new evidence In other words, people may underreact to news, so prices reflect news gradually and thus the momentum effect is formed,Information

10、Processing Problems,Representativeness bias (代表性偏誤) People are too prone to believe that a small sample is representative of a population and infer patterns too quickly and thus extrapolate trends too far into the future This kind of bias is also called the sample size neglect bias because people of

11、ten neglect that the sample size is too small to derive reliable forecasts Gamblers fallacy In a gamble of tossing a coin, the previous ten results are all heads Since the numbers of heads and tails should be very close in the long run, the gambler concludes that it is with higher probability to hav

12、e tail results for the following tosses Recent good earnings the firm has bright prospects buying pressure bids the price too high, so stocks with the best recent performance usually suffer reversals after the earnings announcements,Behavioral Biases,Framing Effect (框架效果) Decisions are affected by h

13、ow choices are posed 600 patients, 4 treatments Mental accounting (心理帳戶) Individuals segregate decisions into different accounts For example, people with insurance policies (conservative account) also buy lotteries (risk-taking account) Use “capital gains account” vs. “initial investment account” to

14、 explain the momentum effect: “capital gains account” becomes more tolerant of risk, discount cash flows at a lower rate, and thus further push up prices Regret avoidance Prospect theory,Behavioral Biases,Regret avoidance (避免後悔) and Disposition effect (處分效果) Regret is the pain of losing the opportun

15、ities to get better results due to making decisions too late or too early Disposition Effect: People try to avoid regret by realizing capital-gain stocks too early and keeping capital-loss stocks too long (or selling capital-loss stocks too late) Prospect theory (展望理論) Proposed by Kahneman and Tvers

16、ky (1979), and Kahneman is the Nobel Prize winner in 2002 One of the most famous theory in the behavioral finance They design some psychological tests to see how people make decisions when they face different kinds of gambles,Behavioral Biases,The results show that what affects peoples decisions is

17、not their wealth level after the gamble, but the amount of gains or losses from the gamble In addition, people are found to be more sensitive about the losses than the gains (loss aversion) The decrease of the utility from $1 loss is larger than the increase of the utility from $1 gain Moreover, the

18、y find that people will become more willing to take risks to avoid losses than to realize gains (individual becomes risk loving when facing losses) The prospect utility is as follows,Figure 9.1 Prospect Theory, In traditional economics, people are assumed to be risk averse and with a concave utility

19、 function In Prospect Theory, people are risk averse (thus with concave utility function) when facing gains and risk loving (thus with convex utility function) when facing losses,Limits to Arbitrage,Fundamental risk The distortion could get worse or maintain for a long enough horizon such that the e

20、xploitation of that distortion to profit is limited (e.g., a trader may run through his capital or a fund manager may lose his job before the prices go back to the proper level) Implementation difficulties For example, the short sell constraint for mutual fund managers Or short-sellers may have to r

21、eturn the borrowed securities soon after the notice from the broker, that makes the horizon of the short sale uncertain Model risk One always worry that an apparent profit opportunity is due to using a faulty model to value the security,Examples for Arbitrage being Limited,Siamese twin companies In

22、1907, Royal Dutch Petroleum (RDP) and Shell Transport (ST) merged their operations into one firm RDP receives 60% cash flow, and ST receives 40% cash flow, so it can be expected that the price of a RDP share is 1.5 times the price of a ST share The figure on the next slide shows that the relative va

23、lue of the two firms departed form this ratio for a long time Closed-end funds Closed-end funds often sell for substantial discounts or premiums from their net asset values Ross (2002) mathematically prove that if the abnormal return is larger than the expense ratio, i.e., the fund managers performa

24、nce more than compensates for expenses, the closed-end funds is traded at a premium to NAV,Figure 9.2 Pricing of Royal Dutch Relative to Shell (Deviation from Parity),Consistently positive deviation lasting about 7 years, The y-axis is the percentage deviation from the parity ratio of 1.5 From Feb.

25、1993 to Mar. 2000, the ratio between the prices of RDP and ST is constantly larger than 1.5 for about 7 years,Bubbles and Behavioral Economics,From 1995 to 2001, the Nasdaq index increased by a factor of more than 6 This dot-com boom development could be explained by some irrationalities in the beha

26、vioral finance In this period, investors were increasingly confident of their forecasts (overconfidence bias) and apparently extrapolate short-term patterns into the distant future (representativeness bias) The overconfidence arises from the situation in which investors always earn huge capital gain

27、s regardless of what to buy and when to buy The interaction of these two biases creates the bubble from 1995 to 2001,Critiques for the Behavioral Finance,Behavioral finance tries to explain anomalies but does not give guidance of how to exploit these irrationalities Behavioral finance explains each

28、anomaly by some subjective combination of irrationalities from the list of behavioral biases. There is not a unified behavioral theory to explain a range of anomalies It is possible to have contradiction between different theories, e.g., overreaction (from representativeness bias) vs. underreaction

29、(form conservatism bias),9.2 TECHNICAL ANALYSIS AND BEHAVIORAL FINANCE,Technical Analysis and Behavioral Finance,Consistence between the technical analysis and behavioral finance Technicians believe that prices only gradually go back to their intrinsic value (consistent with the momentum effect and

30、the conservatism bias), and they can exploit the slow adjustments to profit Behavioral biases may also be consistent with technical analysts use of volume data to form trading strategy As traders become more overconfident, they may trade more, inducing an association between trading volume and marke

31、t returns Technicians as well as some proponents of the behavioral finance believe that market fundamentals could be affected by irrational or behavioral factors, sometimes labeled sentiment variables (情緒變數(shù)),Technical Analysis and Behavioral Finance,In summary, the authors of this text book believe

32、that The reason why the technical analysts can make profit is actually from exploiting irrationalities of investors rather than finding some useful information or patterns The behavior finance, which is proposed to explain these irrationalities, may provide the theoretical foundation for the workabi

33、lity of technical analyses in financial markets,Some Technical Analysis Method,Dow theory It is the ancestor of trend analysis, created by Charles Dow, who is a journalist, the founder and first editor of the Wall Street Journal, and co-founder of Dow Jones & Company Following Dows death, Hamilton,

34、Rhea and Schaefer organized and collected Dow Theory, based on Dows editorials about financial markets Six basic principles of the Dow theory The market has three factors simultaneously affecting stock prices: primary trends, intermediate trends, and minor trends, see Figures 9.3 and 9.4 A trend hav

35、e three phases The accumulation phase: some foresighted investors are actively trading stock against the general opinion of the market Rapid price change phase: the trend followers or other technically oriented investors catch on to these foresighted investors Final phase: the second phase lasts unt

36、il rampant speculation occurs, and at this point, the foresighted investors begin to distribute their holdings to the market,Figure 9.3 Dow Theory Trends, Primary trend: long-term movements, lasting from months to years Intermediate trend (swing): short-term deviations from the underlying primary tr

37、end, which could retrace from 33% to 66% of the primary movement Minor trend (swing): daily fluctuations which are with little importance in the trend analysis of the Dow theory,Figure 9.4 Dow Jones Industrial Averages in 1988, The pattern of “market peaks” (points B, D, F) and “market lows” (points

38、 A, C, E) is one of the key ways to identify the primary trend Classic upward primary trend: each market peak is higher than the previous market peak (F vs. D vs. B), and each market low is higher than the previous market low (E vs. C vs. A),Some Technical Analysis Method,The stock market reflect al

39、l news quickly: Dow agreed with the efficient market hypothesis in some degree Stock market averages must confirm each other Dow believed that if manufacturers profits are rising, more products should be shipped to customers Hence, the performance of shipping companies, which are mostly railroad com

40、panies in the Dows era, should rises as well So, the industrial average index and the transportation average index should move in the same direction in a real trend Trends are confirmed by volume When price movements are accompanied by high volume, Dow believed this represented the true market view

41、To him, it is a signal that a trend is developing Trends exist until definitive signals prove that they have ended Dow believed that trends existed despite market noise“ However, determining whether a reversal is the start of a new trend or a temporary deviation in the current trend is not easy When

42、 there are definitive signals to prove the existence of a trend, usually the trend is almost ended, i.e., the trends are always recognized after the fact,Some Technical Analysis Method,Point and figure charts The way to construct point and figure charts is shown on the next slide It simply traces si

43、gnificant upward or downward movements in stock prices without regard to their timing Different from other technical analysis, this figure has no time dimension Instead, the aim of this figure is to filter out the noise (unimportant price movement) and focus on finding the main direction of the pric

44、e trend An congestion area is a horizontal band of Xs and Os created by several price reversals, and the upper and lower bounds for an congestion area correspond to the resistance and support levels (see Figure 9.6),Table 9.1 Stock Price History Figure 9.5 Point and Figure Chart, Here the minimal mo

45、vement of stock prices recorded in the point and figure chart is $2, which is customary in setting up a chart to record significant price changes There is a revised method termed log scaling point and figure charts, where the Xs and Os are marked according to a percentage rather than a price change,

46、 which allows the sensitivity of this method to remain constant for high and low prices,Figure 9.6 Dow Jones Industrial Averages in 1988, When the stock price penetrates the resistance (support) level from below (above), it means the market consensus about the prospect of the stock is significantly

47、better (worse) than that in the previous period of time corresponding to the congestion area According to the above logic, buy signals are generated when the stock price penetrates the resistance level from below, and sell signals are generated when the stock price penetrates the support level from

48、above,Moving averages Average price over some historical period (1 week, 4 weeks, or 52 weeks) For each day, the moving average is recomputed by dropping the oldest observation and adding the latest By definition, the long-term moving average is a more smooth series than the short-term moving averag

49、e When the short-term moving average crosses the long-term moving average, a trading signal occurs Bullish signals occur when the short-term upward moving average rises above the long-term upward moving average (in Taiwan, it is called “黃金交叉”) Bearish signals occur when the short-term downward movin

50、g average falls below the long-term downward moving average (in Taiwan, it is called “死亡交叉”),Some Technical Analysis Method,Figure 9.7 Share Price and 50-Day Moving Average for Apple Computer, The line in black represents the daily share prices, which can be viewed as the shortest-term moving averag

51、e, and the line in pink represents the 50-day moving average In this case, both signals provide good forecast about the future movement although they cannot identify the perfect selling and purchasing time points,Breadth The extent to which movements in a broad index are reflected widely in movement

52、s of individual stocks Spread between the number of advancing stocks and declining stocks If the advances outnumber declines by a wide margin, then the market is viewed as being stronger because the upward rally is widespread (see next slide) Relative strength Defined as the ratio of prices of an in

53、dividual stock divided by the level of an industry A rising (declining) ratio implies security has outperformed (underperfomed) the particular industry average If relative outperforming strength can persist over time, then this would be a signal to buy,Some Technical Analysis Method,Table 9.2 Breadt

54、h, The direction of the cumulated breadth series is used to discern market trends When the cumulative breadth increases (decreases), the market is viewed as being stronger (weaker) because the upward (downward) rally is more widespread Analysts might use a moving average of cumulative breadth to gau

55、ge market trends,Sentiment Indicators,Trin Statistics: The trin ratio above 1.0 are considered bearish because the falling stocks would have higher average volume than the advancing stocks, indicating net selling pressure Note carefully that since for every seller, there must be a buyer, the trin ratio above 1.0 also indicates that there is more buying activity in declining stocks,Sentiment Indicators,Confidence index Ratio of the average yield on 10 top-rated corporate bonds divided b