12 Chapter - Behavioral Finance and Technical Analysis
CHAPTER 12: BEHAVIORAL FINANCE AND TECHNICAL ANALYSIS
PROBLEM SETS 1. Technical analysis can generally be viewed as a search for trends or patterns in market prices. Technical analysts tend to view these trends as momentum, or gradual adjustments to correct prices, or, alternatively, reversals of trends. A number of the behavioral biases discussed in the chapter might contribute to such trends and patterns. For example, a conservatism bias might contribute to a trend in prices as investors gradually take new information in to account, resulting in gradual adjustment of prices towards their fundamental values. Another example derives from the concept of representativeness, which leads investors to inappropriately conclude, on the basis of a small sample of data, that a pattern has been established that will continue well in to the future. When investors subsequently become aware of the fact that prices have overreacted, corrections reverse the initial erroneous trend. Even if many investors exhibit behavioral biases, security prices might still be set efficiently if the actions of arbitrageurs move prices to their intrinsic values. Arbitrageurs who observe mispricing in the securities markets would buy underpriced securities (or possibly sell short overpriced securities) in order to profit from the anticipated subsequent changes as prices move to their intrinsic values. Consequently, securities prices would still exhibit the characteristics of an efficient market. One of the major factors limiting the ability of rational investors to take advantage of any pricing errors that result from the actions of behavioral investors is the fact that a mispricing can get worse over time. An example of this fundamental risk is the apparent ongoing overpricing of the NASDAQ index in the late 1990s. A related factor is the inherent costs and limits related to short selling, which restrict the extent to which arbitrage can force overpriced securities (or indexes) to move towards their fair values. Rational investors must also be aware of the risk that an apparent mispricing is, in fact, a consequence of model risk; that is, the perceived mispricing may not be real because the investor has used a faulty model to value the security.
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Two reasons why behavioral biases might not affect equilibrium asset prices are discussed in Quiz Problems (1) and (2) above: first, behavioral biases might contribute to the success of technical trading rules as prices gradually adjust towards their intrinsic values, and; second, the actions of arbitrageurs might move security prices towards their intrinsic values. It might be important for investors to be aware of these biases because either of these scenarios might create the potential for excess profits even if behavioral biases do not affect equilibrium prices. Efficient market advocates believe that publicly available information (and, for advocates of strong-form efficiency, even insider information) is, at any point in time, reflected in securities prices, and that price adjustments to new information occur very quickly. Consequently, prices are at fair levels so that active management is very unlikely to improve performance above that of a broadly diversified index portfolio. In contrast, advocates of behavioral finance identify a number of investor errors in information processing and decision making that could result in mispricing of securities. However, the behavioral finance literature generally does not provide guidance as to how these investor errors can be exploited to generate excess profits. Therefore, in the absence of any profitable alternatives, even if securities markets are not efficient, the optimal strategy might still be a passive indexing strategy. Volume declining / Number declining 766,901,460 / 2,068 = = 0.978 Volume advancing / Number advancing 467,560,150 / 1,233
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Trin =
This trin ratio, which is below 1.0, would be taken as a bullish signal. 7. Breadth: Advances 1,233 Declines 2,068 Net Advanc es -835
Breadth is negative. This is a bearish signal (although no one would actually use a oneday measure as in this example). 8. 9. This exercise is left to the student; answers will vary. The confidence index increases from (7%/8%) = 0.875 to (8%/9%) = 0.889 This indicates slightly higher confidence. But the real reason for the increase in the index is the expectation of higher inflation, not higher confidence about the economy.
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At the beginning of the period, the price of Computers, Inc. divided by the industry index was 0.39; by the end of the period, the ratio had increased to 0.50. As the ratio increased over the period, it appears that Computers, Inc. outperformed other firms in its industry. The overall trend, therefore, indicates relative strength, although some fluctuation existed during the period, with the ratio falling to a low point of 0.33 on day 19. Five day moving averages: Days 1 5: (19.63 + 20 + 20.5 + 22 + 21.13) / 5 = 20.65 Days 2 6 = 21.13 Days 3 7 = 21.50 Days 4 8 = 21.90 Days 5 9 = 22.13 Days 6 10 = 22.68 Days 7 11 = 23.18 Days 8 12 = 23.45 Sell signal (day 12 price < moving average) Days 9 13 = 23.38 Days 10 14 = 23.15 Days 11 15 = 22.50 Days 12 16 = 21.65 Days 13 17 = 20.95 Days 14 18 = 20.28 Days 15 19 = 19.38 Days 16 20 = 19.05 Days 17 21 = 18.93 Buy signal (day 21 price > moving average) Days 18 22 = 19.28 Days 19 23 = 19.93 Days 20 24 = 21.05 Days 21 25 = 22.05 Days 22 26 = 23.18 Days 23 27 = 24.13 Days 24 28 = 25.13 Days 25 29 = 26.00 Days 26 30 = 26.80 Days 27 31 = 27.45 Days 28 32 = 27.80 Days 29 33 = 27.90 Sell signal (day 33 price < moving average) Days 30 34 = 28.20 Days 31 35 = 28.45 Days 32 36 = 28.65 Days 33 37 = 29.05 Days 34 38 = 29.25 Days 35 39 = 29.00 Days 36 40 = 28.75
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This pattern shows a lack of breadth. Even though the index is up, more stocks declined than advanced, which indicates a lack of broad-based support for the rise in the index.
13. Day 1 2 3 4 5 6 7 8 9 10 Advances 906 653 721 503 497 970 1,002 903 850 766 Declines 704 986 789 968 1,095 702 609 722 748 766 Net Advanc es 202 -333 - 68 -465 -598 268 393 181 102 0 Cumulative Breadth 202 -131 -199 -664 -1,262 -994 -601 -420 -318 -318
The signal is bearish as cumulative breadth is negative; however, the negative number is declining in magnitude, indicative of improvement. Perhaps the worst of the bear market has passed. Volume declining/ Number declining 240 million / 704 = = 0.936 Volume advancing/ Number advancing 330 million / 906
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Trin =
This is a slightly bullish indicator, with average volume in advancing issues a bit greater than average volume in declining issues. Yield on top - rated corporate bonds Yield on intermedia te - grade corporate bonds
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Confidence Index =
This year: Confidence Index = (8%/10.5%) = 0.762 Last year: Confidence Index = (8.5%/10%) = 0.850 Thus, the confidence index is decreasing. 16. [Note: In order to create the 26-week moving average for the S&P 500, we first converted the weekly returns to weekly index values, using a base of 100 for the week prior to the first week of the data set. The graph on the next page shows the resulting S&P 500 values and the 26-week moving average, beginning with the 26th week of the data set.] a.The graph on the next page summarizes the data for the 26-week moving average. The graph also shows the values of the S&P 500 index.
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b.
The S&P 500 crosses through its moving average from below fourteen times, as indicated in the table below. The index increases seven times in weeks following a cross-through and decreases seven times. Date of Direction of S&P 500 cross-through in subsequent week 05/18/01 Decrease 06/08/01 Decrease 12/07/01 Decrease 12/21/01 Increase 03/01/02 Increase 11/22/02 Increase 01/03/03 Increase 03/21/03 Decrease 04/17/03 Increase 06/10/04 Decrease 09/03/04 Increase 10/01/04 Decrease 10/29/04 Increase 04/08/05 Decrease
c.The S&P 500 crosses through its moving average from above fourteen times, as indicated in the table below. The index increases nine times in weeks following a cross-through and decreases five times. Date of Direction of S&P 500 cross-through in subsequent week 06/01/01 Increase 06/15/01 Increase 12/14/01 Increase 02/08/02 Increase 04/05/02 Decrease 12/13/02 Increase 01/24/03 Decrease 03/28/03 Increase 04/30/04 Decrease 07/02/04 Decrease 09/24/04 Increase 10/15/04 Decrease 03/24/05 Increase 04/15/05 Increase d. When the index crosses through its moving average from below, as in part (b) above, this is regarded as a bullish signal. However, in our sample, the index is as likely to increase as it is to decrease following such a signal. When the index crosses through its moving average from above, as in part (c), this is regarded as a bearish signal. In our sample, contrary to the bearish signal, the index is actually more likely to increase than it is to decrease following such a signal.
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[Note: In order to create the relative strength measure, we first converted the weekly returns for the Fidelity Banking Fund and for the S&P 500 to weekly index values, using a base of 100 for the week prior to the first week of the data set. The graph on the next page shows the resulting Fidelity Banking Fund values and the S&P 500 values, along with the Relative Strength measure (multiplied by 100). The graph on the following page shows the percentage change in the Relative Strength measure over 5week intervals.] a.The graphs on the next two pages summarize the relative strength data for the Fidelity Banking Fund. b. Over five-week intervals, relative strength increased by more than 5% twenty-nine times, as indicated in the table below. The Fidelity Banking Fund underperformed the S&P 500 index eighteen times and outperformed the S&P 500 index eleven times in weeks following an increase of more than 5%. Date of Increase 07/21/00 08/04/00 08/11/00 08/18/00 09/22/00 09/29/00 10/06/00 12/01/00 12/22/00 12/29/00 01/05/01 01/12/01 02/16/01 02/23/01 03/02/01 03/09/01 03/16/01 03/30/01 06/22/01 08/17/01 03/15/02 03/22/02 03/28/02 04/05/02 04/12/02 04/26/02 05/03/02 05/10/02 06/28/02 Performance of Banking Fund in subsequent week Outperformed Outperformed Underperformed Outperformed Outperformed Underperformed Underperformed Underperformed Underperformed Outperformed Underperformed Underperformed Underperformed Outperformed Underperformed Outperformed Underperformed Underperformed Underperformed Underperformed Outperformed Underperformed Outperformed Outperformed Underperformed Outperformed Underperformed Underperformed Underperformed
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Banking Sector / S&P500 / Relative Strength
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c. Over five-week intervals, relative strength decreases by more than 5% fifteen times, as indicated in the table below. The Fidelity Banking Fund underperformed the S&P 500 index six times and outperformed the S&P 500 index nine times in weeks following a decrease of more than 5%. Performance of Date of Banking Fund in Decrease subsequent week 07/07/00 Underperformed 07/14/00 Outperformed 05/04/01 Underperformed 05/11/01 Outperformed 10/12/01 Outperformed 11/02/01 Outperformed 10/04/02 Outperformed 10/11/02 Outperformed 04/16/04 Underperformed Outperformed 04/23/04 12/03/04 Outperformed 12/10/04 Underperformed 12/17/04 Outperformed 12/23/04 Underperformed 12/31/04 Underperformed d. An increase in relative strength, as in part (b) above, is regarded as a bullish signal. However, in our sample, the Fidelity Banking Fund is more likely to under perform the S&P 500 index than it is to outperform the index following such a signal. A decrease in relative strength, as in part (c), is regarded as a bearish signal. In our sample, contrary to the bearish signal, the Fidelity Banking Fund is actually more likely to outperform the index increase than it is to under perform following such a signal.
CFA PROBLEMS 1. i. Mental accounting is best illustrated by Statement #3. Sampsons requirement that his income needs be met via interest income and stock dividends is an example of mental accounting. Mental accounting holds that investors segregate funds into mental accounts (e.g., dividends and capital gains), maintain a set of separate mental accounts, and do not combine outcomes; a loss in one account is treated separately from a loss in another account. Mental accounting leads to an investor preference for dividends over capital gains and to an inability or failure to consider total return.
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Overconfidence (illusion of control) is best illustrated by Statement #6. Sampsons desire to select investments that are inconsistent with his overall strategy indicates overconfidence. Overconfident individuals often exhibit risk-seeking behavior. People are also more confident in the validity of their conclusions than is justified by their success rate. Causes of overconfidence include the illusion of control, self-enhancement tendencies, insensitivity to predictive accuracy, and misconceptions of chance processes. Reference dependence is best illustrated by Statement #5. Sampsons desire to retain poor performing investments and to take quick profits on successful investments suggests reference dependence. Reference dependence holds that investment decisions are critically dependent on the decision-makers reference point. In this case, the reference point is the original purchase price. Alternatives are evaluated not in terms of final outcomes but rather in terms of gains and losses relative to this reference point. Thus, preferences are susceptible to manipulation simply by changing the reference point.
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a. Frost's statement is an example of reference dependence. His inclination to sell the international investments once prices return to the original cost depends not only on the terminal wealth value, but also on where he is now, that is, his reference point. This reference point, which is below the original cost, has become a critical factor in Frosts decision. In standard finance, alternatives are evaluated in terms of terminal wealth values or final outcomes, not in terms of gains and losses relative to some reference point such as original cost. b. Frosts statement is an example of susceptibility to cognitive error, in at least two ways. First, he is displaying the behavioral flaw of overconfidence. He likely is more confident about the validity of his conclusion than is justified by his rate of success. He is very confident that the past performance of Country XYZ indicates future performance. Behavioral investors could, and often do, conclude that a fiveyear record is ample evidence to suggest future performance. Second, by choosing to invest in the securities of only Country XYZ, Frost is also exemplifying the behavioral finance phenomenon of asset segregation. That is, he is evaluating Country XYZ investment in terms of its anticipated gains or losses viewed in isolation. Individuals are typically more confident about the validity of their conclusions than is justified by their success rate or by the principles of standard finance, especially with regard to relevant time horizons. In standard finance, investors know that five years of returns on Country XYZ securities relative to all other markets provide little information about future performance. A standard finance investor would not be fooled by this law of small numbers. In standard finance, investors evaluate performance in portfolio terms, in this case defined by combining the Country XYZ holding with all other securities held. Investments in Country XYZ, like all other potential investments, should be evaluated in terms of the anticipated contribution to the risk- reward profile of the entire portfolio.
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c.Frosts statement is an example of mental accounting. Mental accounting holds that investors segregate money into mental accounts (e.g., safe versus speculative), maintain a set of separate mental accounts, and do not combine outcomes; a loss in one account is treated separately from a loss in another account. One manifestation of mental accounting, in which Frost is engaging, is building a portfolio as a pyramid of assets, layer by layer, with the retirement account representing a layer separate from the speculative fund. Each layer is associated with different goals and attitudes toward risk. He is more risk averse with respect to the retirement account than he is with respect to the speculative fund account. The money in the retirement account is a downside protection layer, designed to avoid future poverty. The money in the speculative fund account is the upside potential layer, designed for a chance at being rich. In standard finance, decisions consider the risk and return profile of the entire portfolio rather than anticipated gains or losses on any particular account, investment, or class of investments. Alternatives should be considered in terms of final outcomes in a total portfolio context rather than in terms of contributions to a safe or a speculative account. Standard finance investors seek to maximize the mean-variance structure of the portfolio as a whole and consider covariances between assets as they construct their portfolios. Standard finance investors have consistent attitudes toward risk across their entire portfolio.
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a. Illusion of knowledge: Maclin believes he is an expert on, and can make accurate forecasts about, the real estate market solely because he has studied housing market data on the Internet. He may have access to a large amount of real estaterelated information, but he may not understand how to analyze the information nor have the ability to apply it to a proposed investment. Overconfidence: Overconfidence causes us to misinterpret the accuracy of our information and our skill in analyzing it. Maclin has assumed that the information he collected on the Internet is accurate without attempting to verify it or consult other sources. He also assumes he has skill in evaluating and analyzing the real estate-related information he has collected, although there is no information in the question that suggests he possesses such ability. b. Reference point: Maclins reference point for his bond position is the purchase price, as evidenced by the fact that he will not sell a position for less than he paid for it. This fixation on a reference point, and the subsequent waiting for the price of the security to move above that reference point before selling the security, prevents Maclin from undertaking a risk/return-based analysis of his portfolio position.
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c.Familiarity: Maclin is evaluating his holding of company stock based on his familiarity with the company rather than on sound investment and portfolio principles. Company employees, because of this familiarity, may have a distorted perception of their own company, assuming a good company will also be a good investment. Irrational investors believe an investment in a company with which they are familiar will produce higher returns and have less risk than non-familiar investments. Representativeness: Maclin is confusing his company (which may well be a good company) with the companys stock (which may or may not be an appropriate holding for his portfolio and/or a good investment) and its future performance. This can result in employees overweighting their company stock, thereby holding an underdiversified portfolio 4. a. The behavioral finance principle of biased expectations/overconfidence is most consistent with the investors first statement. Petrie stock provides a level of confidence and comfort for the investor because of the circumstances in which she acquired the stock and her recent history with the returns and income from the stock. However, the investor exhibits overconfidence in the stock given the needs of the Trust and the brevity of the recent performance history. Maintaining a 15 percent position in a single stock is inconsistent with the overall strategy of the Trust, and the investors level of confidence should reflect the stocks overall record, not just the past two years. b. The behavioral finance principle of mental accounting is most consistent with the investors second statement. The investor has segregated the monies distributed from the Trust into two accounts: the returns the Trust receives from the Petrie stock, and the remaining funds that the Trust receives for her benefit. She is maintaining a separate set of mental accounts with regard to the total funds distributed. The investors specific uses should be viewed in the overall context of the spending needs of the Trust and should consider the risk and return profile of the entire Trust.
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i. Overconfidence (Biased Expectations and Illusion of Control): Pierce is basing her investment strategy for supporting her parents on her confidence in the economic forecasts. This is a cognitive error reflecting overconfidence in the form of both biased expectations and an illusion of control. Pierce is likely more confident in the validity of those forecasts than is justified by the accuracy of prior forecasts. Analysts consensus forecasts have proven routinely and widely inaccurate. Pierce also appears to be overly confident that the recent performance of the Pogo Island economy is a good indicator of future performance. Behavioral investors often conclude that a short track record is ample evidence to suggest future performance.
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Standard finance investors understand that individuals typically have greater confidence in the validity of their conclusions than is justified by their success rate. The calibration paradigm, which compares confidence to predictive ability, suggests that there is significantly lower probability of success than the confidence levels reported by individuals. In addition, standard finance investors know that recent performance provides little information about future performance and are not deceived by this law of small numbers. ii. Loss Aversion (Risk Seeking): Pierce is exhibiting risk aversion in deciding to sell the Core Bond Fund despite its gains and favorable prospects. She prefers a certain gain over a possibly larger gain coupled with a smaller chance of a loss. Pierce is exhibiting loss aversion (risk seeking) by holding the High Yield Bond Fund despite its uncertain prospects. She prefers the modest possibility of recovery coupled with the chance of a larger loss over a certain loss. People tend to exhibit risk seeking, rather than risk aversion, behavior when the probability of loss is large. There is considerable evidence indicating that risk aversion holds for gains and risk seeking behavior holds for losses, and that attitudes toward risk vary depending on particular goals and circumstances. Standard finance investors are consistently risk averse, and systematically prefer a certain outcome over a gamble with the same expected value. Such investors also take a symmetrical view of gains and losses of the same magnitude, and their sensitivity (aversion) to changes in value is not a function of a specified value reference point. iii. Reference Dependence: Pierces inclination to sell her Small Company Fund once it returns to her original cost is an example of reference dependence. Her sell decision is predicated on the current value as related to original cost, her reference point. Her decision does not consider any analysis of expected terminal value or the impact of this sale on her total portfolio. This reference point of original cost has become a critical but inappropriate factor in Pierces decision. In standard finance, alternatives are evaluated in terms of terminal wealth values or final outcomes, not in terms of gains and losses relative to a reference point such as original cost. Standard finance investors also consider the risk and return profile of the entire portfolio rather than anticipated gains or losses on any particular investment or asset class.
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