BKM 12: Behavorial Finance and Technical Analysis Flashcards
Behavioral finance
People make a difference
Conventional financial theory ignores how real people make decisions
Irrationalities of individuals
- Investors do not always process information correctly
- Even given a probability distribution of returns, they often make inconsistent or suboptimal decisions
Information processing irrationalities
Forecasting errors (memory bias)
Overconfidence
Conservatism
Sample size neglect
Behavioral biases
Framing
Mental accounting
Regret avoidance
Affect
Prospect theory
Limits to arbitrage
Fundamental risk (presumed underpricing can get worse)
Implementation costs
Model risk
Violations of Law of One Price
Siamese Twin Companies (Royal Dutch/Shell 60/40 split, Royal dutch sold for less)
Equity Carve-outs (3Com = 1.5 Palm, Palm sold for more)
Criticisms of behavioral finance
Approach is too unstructured (anything explained by “irrationalities”
Anomalies are inconsistent in terms of their support for one type of irrationality versus another
Selecting wrong benchmark can cumulate to large abnormalities
Disposition effect
Tendency for investors to hold on to losing investments
Momentum and moving averages
Prices breaking through the moving average from below are taken as bullish signal
Relative strength
Measures the extent to which a security has out- or underperformed either the market as a whole or its particular industry
Breadth of market
Measure of the extent to which movement in a market index is reflected widely in the price movements of all stocks of the market; most common the spread between advances and declines
Trin statistic
Confidence Index
Put/Call Ratio (signal)
Ratio of puts to calls (typically around 65%); put options profit from declining markets – higher ratio, bearish signal
