BKM Chapter 12 - Behavioral Finance and Technical Analysis Flashcards
What are the three major categories of behavioral issues and briefly describe their implications.
- Information Processing Errors: make it difficult for investors to accurately asses probabilities and evaluate risk.
- Behaviroal Biases make it difficult for investors to rationally evaluate risk opportunities using a simple rule to maximize their expected utility. Instead, they fall back on simple rules of thumb or are influenced by more subtle factors, such as regret avoidance.
- Limits to arbitrage make it difficult for investors to exploit the mistakes made by others, allowing prices to deviate from their fundamental value for long periods of time.
Information Processing Errors & Market Anomaly associated with each
- Forecasting Errors - People tend to give too mcuh weight to recent evidence and tend to produce extreme forecasts.
- Market Anomaly: This could lead to excessive earnings forecasts and cause high P/E stocks to subsequently under-perform.
- Overconfidence - People tend to exhibit overconfidence and overestimate their abilities.
- Market Anomaly: Prevalence of active versus passive investment management, since high trading activity is highly predictive of poor investment performance.
- Conservatism - Investors are often slow to update their prior beliefs in the face of new information.
- Market Anomaly: Post-earning-announcement drift which gives rise to momentum in stock market returns.
- Sample Size Neglect and Representativenesss - People tend to infer pattens from limited information.
- Market Anomaly: Evidence that stocks with the best recent performance show reversals in the few days surrounding earnings announcements.
Behavioral Biases
- Framing - Decisions tend to be influenced by the way they are framed. For instance, people tend to be risk averse when it comes to gains (would prefer certain gian to a gamble) but are risk seeking when it comes to losses (would prefer a gamble to a certain loss).
- Mental Accouting - A specific type of framing is when people segregate certain decisions. For example, some gamblers may make different decisions when playing with the house’s money versus when they have to dip into their own funds.
- Regret Avoidance - People tend to blame themselves less when their choice are more conventional, which causes people to shy away from out of favor stocks. This could explain why higher returns are required to entice investors to buy firms with high book to market ratio.
- Prospect Theory - This theory argues that investors often exhibit loss aversion. Their utility does not depend on the level of wealth, but rather on changes in wealth. This means people does not get less risk averse as their wealth rises and they are more risk seeking rather than risk averse when it comes to losses.
Limits to Arbitrage - several factors limit the ability of others to profit from mispricing
Fundamental Risk - If you leverage your bet with borrowed funds, your debt could come due before the price arises. Or if you invest on behalf of clients, they could fire you for the short-term loss before the price rises.
Implementation Costs - Often mispricing cannot be fully exploited due to transaction costs
Model Risk - What if you are wrong? All opportunities to exploit identified mispricings will carry some risk and therefore may limit the willingness to try to exploit it fully.
Define Law of One Price and Describe two examples that violate the Law of One Price.
Law of One Price: Effectively identical assets should have the same price.
Two examples of violation:
- Siamese twins. Royal Dutch/Shell are effectively one company split 60/40. So stock prices should move in sync accordingly, but they didn’t.
- Equity carve-outs. 3com announced its decision to spin off Palm, and gave each shareholder 1.5 Palm share. In theory, 3com stock price should have been higher than Palm’s, but it was not.
What is the behavioral critique of conventional financial theory?
The premise of behavioral finance is that conventional financial theory ignores how people really make decisions under uncertainty.
First, people commonly make errors inferring probability distributions.
Second, even when they know the probability distributions, they often make systematically suboptimal decisions.
Evaluating the Behavioral Critique
Efficient market theory suggests that market prices are to a large extent reliable. The behavioral critique calls this into question, but it fails to offer much evidence that there are exploitable patterns.
The behavioral biases offer a laundry list of interesting behaviors that can be used to explain just about any anomaly. But it does not offer a consistent or unified behavioral theory.
Technical Analysis - Three methos used to indentify momentum
- Dow Theory - It suggests that stock prices are driven by primary trend (the long-term movement in prices), secondary trends (intermediate term movements away from the long term trends, which are eliminated via corrections) and minor trends (the daily fluctuation of little importance).
- Moving Average - Prices relative to a long term moving average may predict a movement toward its true value or may indentify canges in long-term trends. The moving average essentially smoothes out short-term fluctuations and may make it easier to spot changes in trends.
- Breadth - This is measured by comparing the number of winners, those with advancing prices, and losers, those with deciling prices. It indicates the extent to which movement in the index is reflected widely in all of the stocks in the market.
Sentiment Indicators - expamles of tools used to capture changing investor sentiment
- Trin Statistic - Techinical analysts use trading volume to capture the degree to which maket movements are significant - whether there is broad investor participation. The Trin Statistics uses the average volume of declining stocks (volume of declining stocks over the # of declining stocks) as a ratio to the average volume of advancing stocks. Ratios > 1 are considered bearish (negative) because they are thought to indicate net selling pressure.
- Confidence Index - This uses bond market to gauge investor sentiment by calculating the ratio of high grade corporate bond yields to intermediate grage corporate bond yields. When investors are more optimistic, default premiums will shrink and the ratio will move closer to one.
- Put/Call Ratio - The ratio of outstanding put options to outstanding call options, which hovers around 0.65, is thought to be a signal of market sentiment. An increase in the ratio is thought to be bearish as it indicates more investors might be using put options to hedge their risk of falling market.
