CH 8: Behavioral Finance and the Psychology of Investing

Behavioral Finance stems from

Cognitive psychology - The study of how people think, reason, and make decisions.

3 Economic conditions that lead to Market Efficiency

1. Investor rationality

2. Independent deviations from rationality

3. Arbitrage

For a market to be inefficient, all 3 conditions must be absent.

Prospect theory

Investors are much more distressed by prospective losses than they are happy about prospective gains.

People focus on changes in wealth rather than levels of wealth.

3 major judgment errors consistent with the predictions of prospect theory

1. Frame dependence

   Investors often make inconsistent choices if the investment problem is presented in 2 different (but equal) ways.

   Focus on gains and losses, and not overall wealth

   Narrow frames lead to irrational investment decisions

2. Loss Aversion

   Reluctance to sell investments after they have fallen in value.

   You have “Get-eventis.” You think that you can just somehow “get even.”

3. The House Money Effect

   Separating money into 2 buckets. (Money you earned from hard work) and (Windfall money; Money you won)

Home country bias

Investing too heavily in the stock of local companies.

The illusion of knowledge

A belief that the information you hold is superior to information held by other investors.

The Snakebite effect

refers to the unwillingness of investors to take a risk following a loss or a bad experience.

The representativeness heuristic

Concluding that there are casual factors at work behind random sequences.

The Hot-Hand fallacy

The false belief that a person who has experienced success with a random event has a greater chance of further success in the future. Randomness often appears in clusters.

The Gamblers Fallacy

Assuming that a departure from what occurs on average will be corrected in the short-run. Believes that because an event has not happened recently, it has become “overdue”.

Self-attribution bias

Attribute good outcomes to your own skill but blame bad outcomes on others or bad luck

Law of small numbers bias

Belief that a small sample of outcomes always resembles the long-run distribution of outcomes.

Availability bias

Overweight on easily accessible information and under weight info that is hard to obtain. Give more weight to more memorable events.

Wishful thinking bias

You believe what you want to believe despite facts telling you otherwise.

Heuristics

Simplifies the decision-making process by identifying a set of criteria to evaluate.

Fundamental analysis

Uses accounting statements and financial and economic information to assess the economic value of a companys stock.

Technical analysis

relies on investor sentiment, errors in judgment, and historical price trends to predict future stock price movements. Search for bullish (positive) and bearish (negative) signals about stock prices.

Backtesting

Investors can derive thousands of succesful technical analysis by using historical security prices.

Market Sentiment Index

The prevailing mood among investors about the future outlook for an individual security or for the market.

Once 80% of investors are bullish or bearish, a consensus had been reached.

Max value of 1.00 (100%), which occurs when every investor you ask is bearish.

Max value of 0.00 (0%), which occurs when every investor you ask is bullish

When MSI is high, time to buy. When MSI is low, time to go.

Dow Theory

The method attempts to interpret and signal changes in the stock market direction. Identifies 3 forces:

• A primary direction or trend

• A secondary reaction or trend (short-term)

• Daily fluctuations

Short-term secondary trends are eliminated by market corrections.

Daily fluctuations are essentially noise and are of no real importance.

Elliot Waves theory

There is an 8-wave repeating sequence. The first 5 waves are “impulsive” waves. The next 3 waves are a “corrective” sequence.

Waves are collectively expressed as investor sentiment.

A support level

is a price or level below which a stock or the market as a whole is unlikely to go. Profit hunters help support the lower level.

A resistance level

A price or level above which a stock or the market as a whole is unlikely to rise. Profit takers resist the upper level.

A Breakout

Occurs when a stock (or market) passes through either a support or a resistance level.

Closing arms (TRIN) (Trading index)

The ratio of average trading volume in declining issues to average trading volume in advancing issues.

What is published by financial press daily.

Market diaries - Shows the number of stocks that advanced and declined on an index each day.

Fibonacci numbers

A sequence in which each number is the sum of the two previous numbers.