Chapter (12).
- 1. Dr. Muath Asmar Investment & Portfolio Management AN-NAJAH NATIONAL UNIVERSITY Faculty of Graduate Studies
- 2. INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education. Chapter Twelve Behavioral Finance and Technical Analysis
- 3. INVESTMENTS | BODIE, KANE, MARCUS • EMH makes two important predictions 1. Security prices property reflect whatever information is available to investors 2. Active traders will find it difficult to outperform passive strategies such as holding market indexes • Tests of market efficiency have focused on the performance of active trading strategies • Behavioral finance assumes investors are not rational Chapter Overview ©2021 McGraw-Hill Education 12-3
- 4. INVESTMENTS | BODIE, KANE, MARCUS Conventional Finance • Prices are correct and equal to intrinsic value • Resources are allocated efficiently • Consistent with EMH Behavioral Finance • What if investors don’t behave rationally? • Arbitrageurs are limited and therefore insufficient to force prices to match intrinsic value Behavioral Finance ©2021 McGraw-Hill Education 12-4
- 5. INVESTMENTS | BODIE, KANE, MARCUS • Two broad categories of irrationalities 1. Investors do not always process information correctly and therefore infer incorrect probability distributions of future returns 2. Even when given a probability distribution of returns, investors may make inconsistent or suboptimal decisions The Behavioral Critique ©2021 McGraw-Hill Education 12-5
- 6. INVESTMENTS | BODIE, KANE, MARCUS • Limited attention, underreaction, and overreaction • Reliance on heuristics due to limited time/attention • Overconfidence • People tent to overestimate the precision of their beliefs or forecasts, and they tend to overestimate their abilities • Extrapolation and pattern recognition • Representativeness bias • Individuals are adept at discerning patterns, even perceiving patterns that may be illusory • Overly prone to believe these patterns are likely to persist Information Processing ©2021 McGraw-Hill Education 12-6
- 7. INVESTMENTS | BODIE, KANE, MARCUS • Framing • Decisions affected by how choices are described, such as whether uncertainty is posed as potential gains from a low baseline levels, or as losses from a higher baseline value • Mental accounting • Specific form of framing in which people segregate certain decisions • Regret avoidance • Individuals who make decisions that turn out badly have more regret when that decision was more unconventional • Affect and feelings • Investors tend to choose stocks with high affect, driving up prices while simultaneously driving down returns Behavioral Biases ©2021 McGraw-Hill Education 12-7
- 8. INVESTMENTS | BODIE, KANE, MARCUS • Conventional view: Higher wealth provides higher utility, but at a diminishing rate • Behavioral view: Utility depends on changes in wealth from current levels, not the level of wealth Behavioral Biases: Prospect Theory ©2021 McGraw-Hill Education 12-8
- 9. INVESTMENTS | BODIE, KANE, MARCUS • 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” -- Keynes • Intrinsic value and market value may take too long to converge Limits to Arbitrage (1 of 2) ©2021 McGraw-Hill Education 12-9
- 10. INVESTMENTS | BODIE, KANE, MARCUS • 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 actually is correct? Limits to Arbitrage (2 of 2) ©2021 McGraw-Hill Education 12-10
- 11. INVESTMENTS | BODIE, KANE, MARCUS • “Siamese Twin” Companies • Royal Dutch should sell for 1.5 times Shell • Deviated from parity ratio for extended periods • Example of fundamental risk Limits to Arbitrage and the Law of One Price (1 of 2) ©2021 McGraw-Hill Education 12-11
- 12. INVESTMENTS | BODIE, KANE, MARCUS • Equity Carve-Outs • Examples: 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 Limits to Arbitrage and the Law of One Price (2 of 2) ©2021 McGraw-Hill Education 12-12
- 13. INVESTMENTS | BODIE, KANE, MARCUS • Bubbles are easier to spot after they end • Dot-com bubble • 6-year period beginning in 1995 • Overconfidence and representativeness biases • Housing bubble • Set off worst financial crisis in 75 years Bubbles and Behavioral Economics (1 of 2) ©2021 McGraw-Hill Education 12-13
- 14. INVESTMENTS | BODIE, KANE, MARCUS • Rational explanation for stock market bubble using the dividend discount model: • S&P 500 is worth $12,883 million if dividend growth rate is 8% (close to actual value in 2000) • S&P 500 is worth $8,589 million if dividend growth rate is 7.4% (close to actual value in 2002) Bubbles and Behavioral Economics (2 of 2) ©2021 McGraw-Hill Education 12-14 gk D PV 1 0
- 15. INVESTMENTS | BODIE, KANE, MARCUS • Technical analysis attempts to exploit recurring and predictable patterns in stock prices to generate superior investment performance • Prices adjust gradually to a new equilibrium • Market values and intrinsic values converge slowly • Disposition effect • Demand for shares depends on price history • Can lead to momentum in stock prices Technical Analysis and Behavioral Finance ©2021 McGraw-Hill Education 12-15
- 16. INVESTMENTS | BODIE, KANE, MARCUS • Momentum and moving averages • The moving average is the average price over a given time interval, where the interval updates as time passes • Bullish signal signifies a shift from a falling trend to a rising trend • Bearish signal signifies price series crossing from above the moving average to below it, representative of the beginning of a downward trend in stock prices Trends and Corrections ©2021 McGraw-Hill Education 12-16
- 17. INVESTMENTS | BODIE, KANE, MARCUS Share Price and 50-Day Moving Average for INTC ©2021 McGraw-Hill Education 12-17
- 18. INVESTMENTS | BODIE, KANE, MARCUS • Relative strength • Measures the extent to which a security has outperformed or underperformed either the market as a whole or its particular industry • Calculated as the ratio of the price of the security to a price index for the industry • Strength of industry relative to the whole market • Computed by tracking the ratio of the industry price index to the market price index Technical Analysis: Relative Strength ©2021 McGraw-Hill Education 12-18
- 19. INVESTMENTS | BODIE, KANE, MARCUS • Breadth • Measure of the extent to which movement in a market index is reflected widely in the price movements of all the stocks in the market • Most common measure is the spread between the number of stocks that advance and decline in price Technical Analysis: Breadth ©2021 McGraw-Hill Education 12-19
- 20. INVESTMENTS | BODIE, KANE, MARCUS • Trin statistic • Ratios above 1.0 are bearish • Rising volume in a rising market should not necessarily indicate a larger imbalance of buyers versus sellers Technical Analysis: Sentiment Indicators (1 of 3) ©2021 McGraw-Hill Education 12-20 Volume declining Number declining Trin = Volume advancing Number advancing
- 21. INVESTMENTS | BODIE, KANE, MARCUS • Confidence index • Ratio of the average yield on 10 top-rated corporate bonds divided by the average yield on 10 intermediate-grade corporate bonds • Ratio will always be below 1 • Higher values are bullish signals Technical Analysis: Sentiment Indicators (2 of 3) ©2021 McGraw-Hill Education 12-21
- 22. INVESTMENTS | BODIE, KANE, MARCUS • Short interest • Total number of shares of stock current sold short • Increased short interest reflects negative sentiment and is a warning sign concerning the stock’s prospects • Put/call ratio • Ratio of outstanding put options to outstanding call options • Rising ratio is taken as a sign of broad investor pessimism and a coming market decline Technical Analysis: Sentiment Indicators (3 of 3) ©2021 McGraw-Hill Education 12-22
- 23. INVESTMENTS | BODIE, KANE, MARCUS • It is possible to perceive patterns that really don’t exist • Figure 12.6A is based on the real data • The graph in panel B was generated using “returns” created by a random-number generator • Figure 12.7 shows obvious randomness in the weekly price changes behind the two panels in Figure 12.6 Technical Analysis: A Warning ©2021 McGraw-Hill Education 12-23
- 24. INVESTMENTS | BODIE, KANE, MARCUS Actual and Simulated Levels for Stock Market Prices of 52 Weeks ©2021 McGraw-Hill Education 12-24
- 25. INVESTMENTS | BODIE, KANE, MARCUS Actual and Simulated Changes in Stock Prices for 52 Weeks ©2021 McGraw-Hill Education 12-25