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

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 1
 Where
WhereAre
Are We?
We?
How?
Securities
Markets
Institutions
Trading
Delegated investment
Why?
Market efficiency
Historical performance

What?
Stock
Bond
Evaluation
International

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 2
 Where
WhereAre
Are We?
We?
How?
Securities
Markets
Institutions
Trading
Delegated investment
Why?
Market efficiency
Historical performance
What?
Stock
Bond
Evaluation
International
So What?

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 3
 Behavioral
Behavioral Finance
Finance and
and Technical
TechnicalAnalysis
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.

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 4
 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
Chapter 12: Behavioral Finance and Technical Analysis
Fin 2802, Spring 10 - Tang 5
 Individual
Individual Behavior
Behavior

• Cooperation and Altruism

• Bidding and the Winner’s Curse

• Endowment Effect, Status Quo Bias and Loss

Aversion

• Mental Accounts

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 6
 Figure
Figure 12-1
12-1 Loss
LossAversion
Aversion Preference
Preference Function
Function

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 7
 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

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 8
 Limits
Limits to
toArbitrage
Arbitrage
• Fundamental Risk
• Implementation Costs
• Model Risk

• Siamese Twin Companies

• Equity Carve-outs
• Closed-End Funds

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 9
 Figure
Figure12.2
12.2Pricing
Pricingof
ofRoyal
RoyalDutch
DutchRelative
Relativeto
toShell
Shell(Deviation
(Deviationfrom
fromParity)
Parity)

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 10
 Technical
TechnicalAnalysis
Analysis

• Attempts to exploit stock price patterns for

profit.

• Assumes prices adjust slowly to their true

equilibrium values

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 11
 Technical
TechnicalAnalysis
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.

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 12
 Technical
TechnicalAnalysis
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); Odd-
lot 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;
Chapter 12: Behavioral Finance and Technical Analysis
Fin 2802, Spring 10 - Tang 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.

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 14
 Figure
Figure 19-2
19-2 Dow
Dow Theory
Theory Trends
Trends

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 15
 Figure
Figure 19-3
19-3 Dow
DowJones
JonesIndustrial
IndustrialAverages
Averages in
in 1988
1988

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 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

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 17
 Figure
Figure 19-4
19-4 Point
Point and
and Figure
Figure Chart
Chart for
forTable
Table 19-2
19-2

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 18
 Table
Table 19-2
19-2 Stock
Stock Price
Price History
History

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 19
 Figure
Figure 19-5
19-5 Point
Point and
and Figure
FigureChart
Chart for
forAtlantic
AtlanticRichfield
Richfield

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 20
 Figure
Figure 19-6
19-6 Candlestick
Candlestick Chart
Chart

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 21
 Charting:
Charting:AAWarning
Warning
A Warning:

• Seeing patterns that don’t 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.

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 22
 Figure
Figure 19-7
19-7Actual
Actual and
and Simulated
Simulated Stock
Stock Prices
Prices for
for52
52Weeks
Weeks

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 23
 Figure
Figure 19-8
19-8Actual
Actual and
and Simulated
Simulated Changes
Changes
in
in Weekly
Weekly Stock
Stock Prices
Prices for
for 52
52 Weeks
Weeks

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 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 heavyinvestors should be bullish.

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 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?

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 26
 Technical
Technical Indicators:
Indicators: Flows
Flows of
of Funds
Funds

• Short Interest: The volume of short selling

High volume investors should be bearish.
Low volumeinvestors should be bullish.
or
High volume investors should be bullish.
Low volumeinvestors should be bearish.

• Credit Balances in Brokerage Accounts

High balance bullish

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 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

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 28
 Technical
Technical Indicators:
Indicators: Market
Market Structure
Structure

Moving Average: Average over a given interval,

continuously updated.
Price
Price
Bullish Signal
And
M.A.
Bearish Signal

Moving Average
Time
Averaging interval

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 29
 Figure
Figure 19-10
19-10 Moving
MovingAverage
Average for
forMicrosoft
Microsoft

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 30
 Figure
Figure 19-11
19-11 Moving
MovingAverages
Averages

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 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 of an Industry
Price Index for the Industry or Market Price Index

Persistent Rising ratio  bullish. “Momentum”

Persistent Falling ratio bearish. Strategies
Chapter 12: Behavioral Finance and Technical Analysis
Fin 2802, Spring 10 - Tang 32
 Figure
Figure 19-12
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

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 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

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 34
 Figure
Figure 19-13
19-13 Record
Record of
ofValue
Value Line
Line Ranking
Ranking for
forTimeliness
Timeliness
(without
(without adjustment
adjustment for
forchange
change inin rankings)
rankings) 1965-1990
1965-1990

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 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

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 36
 Technical
TechnicalAnalysis
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)
Chapter 12: Behavioral Finance and Technical Analysis
Fin 2802, Spring 10 - Tang 37
 A
ANew
New View
View of
of Technical
TechnicalAnalysis
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

Chapter 12: Behavioral Finance and Technical Analysis
Fin 2802, Spring 10 - Tang 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

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang 39