chapter 12 note - Chapter12 Behavioral Finance and...

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1 Chapter 12 Behavioral Finance and Technical Analysis By Dr. M. Metghalchi BEHAVIORAL FINANCE: BF is a challenge to Efficient Market Hypothesis (EMH); the EMH is the bread and butter of the modern finance theory that are taught at all business schools around the world. Fama (1970, “Efficient Capital Markets: A review of theory and empirical work”, journal of Finance, 25:383-417) defined an efficient financial market as one in which security prices always fully reflect the available information; any new information will be quickly and instantaneously reflected in prices, any deviation from the intrinsic value of a security will be corrected quickly by arbitrageurs. Furthermore, since news on any company, by definition, is unpredictable (arrives randomly), price changes will be unpredictable or follow a random walk. The Efficient Market Hypothesis (EMH) asserts that stock prices already reflect all publicly available information and any other information that can be derived by investigating market trading data such as the history of past prices or trading volume. Advocates of the EMH argue that investors could not drive profits above a buy-and-hold strategy using technical analysis or fundamental analysis. Two of the most important assumptions of the EMH are that all investors behave rationally and arbitrage eliminates pricing anomalies. After more than three decades of research and literally thousands of journal articles, financial economists and practitioners have not yet reached a consensus whether technical analysis or fundamental approach to investing could beat the market (Buy-and-Hold strategy). The overwhelming majority of financial economists support the efficient market hypothesis. This is because much of earlier research supported the random walk hypothesis. However since the early1990s, technical trading and BEHAVIORAL FINANCE have been enjoying a renaissance both on Wall Street and in academic circles. Behavioral Finance is theoretical challenge to EMH and technical analysis is empirical challenge to EMH.
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2 Proponents of the Behavioral Finance argue that investors sometimes make errors in judgment (Not always rational). How these errors and mistakes affect investors and asset prices falls under the general heading of "behavioral finance. In the first part of this chapter, the goal is to acquaint you with some common types of mistakes investors make and their financial implications. As you will see, researchers have identified a wide variety of potentially damaging (irrational) behaviors. In the second part of the chapter, a trading strategy known as technical analysis is presented. Some investors use technical analysis as a tool to try to exploit patterns in prices. These patterns are thought to exist (by advocates of technical analysis) because of predictable behavior by investors.
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chapter 12 note - Chapter12 Behavioral Finance and...

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