Chapter 9 Behavioral Finance Biases they bid stock prices too high new information arrives Framing Errors mental accounting raise the money be greater extrapolation Analysts tend to excessively extrapolate historical trends when forecasting overconfidence some people believe that risk will hurt the other person but not them As a result anchoring Many people become anchored to their ideas and will not update their expectations when o When cash is needed investors may spend dividends but refuse to sell a small portion of stock to o This may lead to a preference for stocks that pay larger dividends even though tax liability may Regret Avoidance Regret from losses is greater than joy from gains o Regret is reduced with shared pain o In order to induce investors to buy out of favor stocks stocks with poor recent performance for example value stocks these stocks have to pay a higher expected return Theories Standard Utility Theory of Investments utility loss from losing 1 000 This gives rise to risk aversion Prospect Theory o Investors desire more wealth and less risk o Wealth provides diminishing marginal utility thus a gain of 1 000 provides less utility than the o investor utility depends on the change in wealth from the start of the investment rather than on the starting level of wealth Limits to Arbitrage fundamental risk changes in fundamentals can wipe out any arbitrage profits making strategy risky short sale constraints make it difficult to arbitrage overpriced securities model risk How do you know when a security is truly mispriced Your model may be giving you wrong signals Technical Analysis Behavioral Finance 1 Conceptual basis o All technical analysis TA assumes that there are recurring and predictable patterns in stock prices which can be exploited to earn abnormal returns o Technical analysts believe Market prices conform to new data only slowly giving rise to price trends Prices are affected by predictable behavioral or psychological factors 2 Identifying trends using moving averages 3 Dow Theory a Three types of trends only two are important b Every stock has price peaks and troughs but if a series of peaks and troughs are rising it is a buy signal especially if volume is heavier during the peaks than the troughs 4 Relative Strength A simple relative strength ratio could be constructed as Pi Index a Increases in the relative strength ratio indicate the stock is outperforming the index and could indicate a buy or bullish signal 5 Breadth a Breadth is the extent to which movements in a broad index are reflected widely in movements of individual stocks b Measured as the difference between the number of advancing and declining stocks a Odd Lot traders are mostly individual investors that are relatively uninformed b Contrarian philosophy Do the opposite of the majority of the odd lot traders a Total number of shares of stock currently sold short b High short interest may indicate that a stock s price is expected to fall Trin volume declining number declining volume advancing number advancing 6 Odd Lot index 7 Short Interest 8 Trin Statistic TA Sentiment Indicators Confidence index o Ratio of the average yield on 10 top rated corporate bonds divided by the average yield on 10 intermediate grade corporate bonds Put call ratio o Call options give investors the right to buy at a fixed exercise price and a put is the right to sell at a fixed exercise price o Change in ratio can be given a bullish or bearish interpretation
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