Chapter 12: Behavioral Finance and Technical Analysis
Terms in this set (28)
Models of financial markets that emphasize implications of psychological factors affecting investing behavior.
Notion that investors are too slow to update their beliefs in response to new evidence. Example: the initial underreaction to news about a firm causing a momentum in stock market returns.
People seem to believe that a small sample is just as representative of a broad population as a large one and therefore infer patterns too quickly.
Interestingly, stocks with the best recent performance suffer reversals precisely in the few days surrounding earnings announcements, suggesting that the correction occurs just s investors learn that their initial beliefs were too extreme.
Decisions are affected by how choices are described, for example, whether uncertainty is posed as potential gains from low baseline level, or as losses from a higher baseline value.
Example: An individual may reject a bet when it is posed in terms of the risk surrounding possible gains, but may accept that same bet when described in terms of the risk surrounding potential losses.
Individuals mentally segregate assets into independent accounts rather than viewing them as part of a unified portfolio.
Example: taking on risky positions in your account, but conservative positions in your daughter's graduation account. It may be most rational to view both accounts as one account with one risk measure.
Notion from behavioral finance that individuals who make decisions that turn out badly will have more regret when that decision was more unconventional.
Example: buying a blue-chip portfolio that turns down is not as painful as experiencing the same losses on an unknown start-up firm. Losses on the blue chip can be more easily attributed to bad luck rather than bad decision making.
Behavioral (as opposed to rational) model of investor utility. Investor utility depends on changes in wealth rather than level of wealth. Utility is more fluid and presently adjusted. This could account for the presence of high risk premiums in equity stocks.
Risk that even if an asset is mispriced, there is still no arbitrage opportunity, because the mispricing can widen before price eventually converges to intrinsic value.
Example: Short-selling a stock to early, even if correct, can still leave an investor broke. NASDAQ example on page 394. "Markets can remain irrational longer than you can remain solvent." - John Maynard Keynes.
The tendency of investors to hold on to losing investments. Can lead to momentum in stock prices even if fundamental values follow a random walk.
The extent to which a security has outperformed or underperformed either the market as a whole or its particular industry.
The extent to which movements in the broad market index are reflected widely in movements of individual stock prices.
The most common measure of this is the spread between the number of stocks that advance and decline in price. If advances outnumber declines by a wide margin, the market is perceived as stronger.
The cumulative of this measure for each day is calculated by adding the day's net advances (or declines) to the previous day's total.
Ratio of average trading volume in declining stocks to average volume in advancing stocks. Used in technical analysis. Technicians consider market advances to be a more favorable omen of continued price increases when they are associated with high trading volume. Be careful, however, because volume doesn't necessarily equal performance. For every buyer, there must be a seller.
(volume declining / number declining) / (volume advancing / number advancing)
Ratio of the yield of top-rated corporate bonds to the yield on intermediate-grade bonds.
The ratio will always be below 100% because the higher-rated bonds will offer lower yields-to-maturity. When bond traders are optimistic about the economy, they might offer smaller default premiums on lower-rated debt, thus the spread will narrow and approach 100%. Higher values of this index are bullish.
Ratio of put options to call options outstanding in a stock.
Typically this ratio hovers around 65%. Deviations of the ratio from historical norms are considered to be a signal of market sentiment, and therefore predictive of market movements. Technicians see a high ratio as bearish, whereas contrarian investors may see a bearish market as a good time to buy due to low prices.
the P/E effect
A forecasting error in which earnings expectations are too extreme. High P/E firms tend to be poor investments.
Information processing bias in which people tend to overestimate their abilities. Men do this way more than women, and therefore tend to make more harmful risky decisions.
Example: This could be an indicator of the preference of trading individual stocks over indexing, despite their higher reliability. Only about 15% of the equity in the mutual fund industry is held in indexed accounts.
the house money effect
A type of mental accounting in gambling in which gamblers are more willing to accept new bets if they currently are ahead. People tend to see the bet as being made from their "winnings account" as the casino's money.
Similarly, individuals my view their investments as largely funded from their "capital gains account" and become more risk tolerant, discounting future cash flows at a lower rate and therefor pushing up prices.
A feeling of good or bad that consumers may attach to a potential purchase or investors to a stock.
Example: companies with good working conditions or popular products may have better affect in the public perception, even if their returns don't match. If investors favor stocks with good affect, that might drive up prices and drive down average rates of return.
Study: Statman, Fisher, and Anginer found that stocks ranked high in Fortune's survey of most admired companies (with high affect) tended to have lower average risk-adjusted returns than the least admired firms, suggesting that their prices had been bid up relative to their underlying profitability.
limits to arbitrage
1. fundamental risk
2. implementation costs
3. model risk
limits of arbitrage and the law of one price
1. "siamese twin" companies: Royal Dutch and Shell splitting profits 60/40, but short-selling according to this deal and the stock price would have lost money
2. equity carve-outs: 3Com selling its Palm division shares in a 5% IPO, then divvying up the rest to 3Com shareholders. Palm ended up selling for more than 3Com and a short-sell position wasn't on the table due to virtually all of the shares already being borrowed and sold short.
3. closed-end funds: nearly a violation of the law of one price. explain further, page 397
constant-growth dividend discount model
Value = Dividend / (Discount rate - Growth rate)
The growth rate can be highly sensitive and a small change can provide a big difference in price. Used to illustrate how bubbles can pop if the growth rate falls.
Relative strength statistics
Designed to uncover the potential opportunities of momentum fluctuations and trends as a stock reaches equilibrium.
The average price over a given interval, where that interval is updated as time passes. For example, a 50-day moving average traces the average price over the previous 50 days. This is a good indicator of price momentum.
This measure lags steep drops and gains because it averages the previous prices in.
Elliot wave theory
Superimposes long-term and short-term wave cycles in an attempt to describe the complicated pattern of actual price movements.
Once the longer-term waves are identified, investors presumably can buy when the long-term direction of the market is positive.
Named after a Russian economist who asserted that the macroeconomy moves in broad waves lasting between 48 and 60 years. This assertion is difficult to evaluate due to the sparseness of data points.
The general level of optimism among investors.
Company that computes a confidence index using data from the bond market, presuming that the actions of bond traders reveal trends that will soon emerge in the stock market.