CH 12

CHAPTER 12
Behavioral Finance and Technical

Analysis
INVESTMENTS | BODIE, KANE, MARCUS

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
12-2
Behavioral Finance
Conventional Finance Behavioral Finance

• Prices are correct; • What if investors don’t
equal to intrinsic behave rationally?
value.
• Resources are
allocated efficiently.
• Consistent with EMH

12-3
The Behavioral Critique

Two categories of irrationalities:
1. Investors do not always process
information correctly.
• Result: Incorrect probability
distributions of future returns.
2. Even when given a probability distribution
of returns, investors may make
inconsistent or suboptimal decisions.
• Result: They have behavioral biases.

12-4
Errors in Information Processing:

Misestimating True Probabilities
1. Forecasting Errors: 3. Conservatism: Investors
Too much weight is are slow to update their
placed on recent beliefs and under react to
experiences. new information.
2. Overconfidence: 4. Sample Size Neglect and

Investors Representativeness:
overestimate their Investors are too quick to
abilities and the infer a pattern or trend
precision of their from a small sample.
forecasts.

12-5
Behavioral Biases
• Biases result in less than rational
decisions, even with perfect
information.
Examples:
1.Framing:
– How the risk is described, “risky losses”
vs. “risky gains”, can affect investor
decisions.
12-6
Behavioral Biases
2. Mental Accounting:
• Investors may segregate accounts or
monies and take risks with their gains
that they would not take with their
principal.
3. Regret Avoidance:
• Investors blame themselves more when
an unconventional or risky bet turns out
badly.

12-7
Behavioral Biases
4. Prospect Theory:
– Conventional view: Utility depends on level of
wealth.
– Behavioral view: Utility depends on changes
in current wealth.

12-8
Figure 12.1 Prospect Theory

12-9
Limits to Arbitrage
• 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.”
– Intrinsic value and market value may
take too long to converge.

12-10
Limits to Arbitrage
• 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 is actually correct?

12-11
Limits to Arbitrage and the

Law of One Price
• Siamese Twin Companies

– Royal Dutch should sell for 1.5
times Shell
– Have deviated from parity ratio
for extended periods
– Example of fundamental risk

12-12
Figure 12.2 Pricing of Royal Dutch Relative

to Shell (Deviation from Parity)

12-13
Limits to Arbitrage and the

Law of One Price
• Equity Carve-outs
– 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
12-14
Bubbles and Behavioral Economics
• Bubbles are easier to spot after

they end.
– Dot-com bubble
– Housing bubble

12-15
Bubbles and Behavioral Economics

• 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).
D1
PV0  • S&P 500 is worth
kg
$8,589 million if dividend
growth rate is 7.4%
(close to actual value in
2002).
12-16
Technical Analysis and Behavioral

Finance
• Technical analysis attempts to exploit
recurring and predictable patterns in stock
prices.
– Prices adjust gradually to a new equilibrium.
– Market values and intrinsic values converge
slowly.

12-17
Technical Analysis and Behavioral

Finance
• Disposition effect: The tendency of
investors to hold on to losing investments.
– Demand for shares depends on price history

– Can lead to momentum in stock prices

12-18
Trends and Corrections:

The Search for Momentum
Dow Theory
1. Primary trend : Long-term movement of
prices, lasting from several months to
several years.
2. Secondary or intermediate trend: short-
term deviations of prices from the
underlying trend line and are eliminated by
corrections.
3. Tertiary or minor trends: Daily fluctuations
of little importance.
12-19
Figure 12.3 Dow Theory Trends

12-20
Trends and Corrections: Moving

Averages
• The moving average • Bullish signal: Market
is the average level of price breaks through
prices over a given the moving average
interval of time. line from below. Time
to buy
• Bearish signal: When
prices fall below the
moving average, it is
time to sell.

12-21
Figure 12.5 Moving Average for HPQ

12-22
Trends and Corrections: Breadth
Breadth: Often
measured as the
spread between
the number of
stocks that
advance and
decline in price.

12-23
Sentiment Indicators:
Trin Statistic
• Trin Statistic:
volume.declining
number.declining
trin 
volume.advancing
number.advancing
Ratios above 1.0 are bearish

12-24
Confidence Index
• Confidence index: • Higher values are
The ratio of the bullish.
average yield on 10
top-rated corporate
bonds divided by the
average yield on 10
intermediate-grade
corporate bonds.

12-25
Put/Call Ratio
• Calls are the right to • A rising ratio may
buy. signal investor
– A way to bet on rising pessimism and a
prices coming market
• Puts are the right to decline.
sell. • Contrarian investors
– A way to bet on falling see a rising ratio as a
prices buying opportunity!

12-26
Warning!
• It is possible to perceive patterns that really
don’t exist.
• Figure 12.8A is based on the real data. The
graph in panel B was generated using
“returns” created by a random-number
generator.
• Figure 12.9 shows obvious randomness in
the weekly price changes behind the two
panels in Figure 12.8
12-27
Figure 12.8 Actual and Simulated Levels for

Stock Market Prices of 52 Weeks

12-28
Figure 12.9 Actual and Simulated Changes

in Stock Prices for 52 Weeks

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CHAPTER 12

Behavioral Finance and Technical

INVESTMENTS | BODIE, KANE, MARCUS

Conventional Finance Behavioral Finance

INVESTMENTS | BODIE, KANE, MARCUS

The Behavioral Critique

INVESTMENTS | BODIE, KANE, MARCUS

Errors in Information Processing:

2. Overconfidence: 4. Sample Size Neglect and

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

Figure 12.1 Prospect Theory

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

Limits to Arbitrage and the

• Siamese Twin Companies

INVESTMENTS | BODIE, KANE, MARCUS

Figure 12.2 Pricing of Royal Dutch Relative

INVESTMENTS | BODIE, KANE, MARCUS

Limits to Arbitrage and the

Bubbles and Behavioral Economics

• Bubbles are easier to spot after

INVESTMENTS | BODIE, KANE, MARCUS

Bubbles and Behavioral Economics

Technical Analysis and Behavioral

INVESTMENTS | BODIE, KANE, MARCUS

Technical Analysis and Behavioral

– Demand for shares depends on price history

INVESTMENTS | BODIE, KANE, MARCUS

Trends and Corrections:

Figure 12.3 Dow Theory Trends

INVESTMENTS | BODIE, KANE, MARCUS

Trends and Corrections: Moving

INVESTMENTS | BODIE, KANE, MARCUS

Figure 12.5 Moving Average for HPQ

INVESTMENTS | BODIE, KANE, MARCUS

Trends and Corrections: Breadth

INVESTMENTS | BODIE, KANE, MARCUS

Ratios above 1.0 are bearish

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

Figure 12.8 Actual and Simulated Levels for

INVESTMENTS | BODIE, KANE, MARCUS

Figure 12.9 Actual and Simulated Changes

INVESTMENTS | BODIE, KANE, MARCUS

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