CH 8: Behavioral Finance and the Psychology of Investing

Behavioral Finance states that investors’ emotions, biases, and reasoning errors influence investment decisions and market prices.

• Stems from Cognitive psychology: the study of how people (including investors) think, reason, and make decisions.

• Reasoning errors are often called cognitive errors.

3 Economic Conditions that Lead to Market Efficiency:

• Investor rationality

• Independent deviations from rationality

• Arbitrage

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

Prospect Theory

Provides an alternative to classical, rational economic decision-making.

Foundation: 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:

Frame dependence

• If an investment problem is presented in two different (but equivalent) ways, investors often make inconsistent choices.

• People tend to focus on gains and losses (narrow frame) and not on the overall wealth (broad frame).

• Narrow frames lead to irrational investment decisions

Loss Aversion

• Loss aversion is a reluctance to sell investments after they have fallen in value. Also known as the “Breakeven” effect or “disposition” effect.

  You have “Get-evenitis”.

  You will think that you can just somehow “get even.”

  You find it difficult to sell a stock at a price lower than your purchase price.

• Anchoring is associating a stock with its purchase price, i.e., fixating on a reference price.

The House Money Effect

• It may seem natural to separate money into two buckets: 1) Money you earned from hard work and 2) Windfall money (House money) (Money you won)

• Irrational. Buys the same amount of goods and services.

  Two important lessons: 1) there are no “paper profits.” Your profit are yours. and 2) Should not separate money into bundles

Overconfidence, Portfolio Diversification, Trading Frequency

Home country bias: Investing too heavily in the stock of local companies.

Overconfidence = likely to trade too much.

More trades = lower returns than investors who trade less frequently

The illusion of knowledge is a belief that the information you hold is superior to information held by other investors.

The Snakebite Effect

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

Considered to have the opposite influence of overconfidence.

Well documented in fund flows to mutual funds. Money tends to be liquidated from mutual funds following some market decline.

Misperceiving Randomness and Overreacting to Chance Events

The representativeness heuristic: Concluding that there are causal factors at work behind random sequences. Or if something is random, it should look random.

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.

Clustering Illusion: Belief that random events that occur in clusters are not really random. Happens in mutual fund investing. Past performance is no guarantee of future results. Investors chase past returns.

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.”

Other Investor Errors and Biases

Law of small numbers bias: Belief that a small sample of outcomes always resembles the long-run distribution of outcomes.

Self-attribution bias: Attribute good outcomes to your own skill but blame bad outcomes on others or bad luck.

False consensus bias: Tendency to think other people are going to make the same decision about a stock we own (leads to overconfidence).

Recency bias: Gives recent events more importance than less recent events.

Availability bias: Overweight on easily accessible information and under weigh information 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.

Herding

Moving together in a quick and pronounced manner.

Taken together with other biases, it might represent the most significant challenge to market efficiency.

If it occurs, expect trends in the market to continue and strengthen for a period of time.

If the market is efficient, knowing these trends will not help investors predict future price changes.

To Overcome Bias

The most important thing is to be aware of potential biases.

Technical Analysis

Unlike Fundamental analysis, which uses accounting statements and financial and economic information to assess the economic value of a company’s stock, Technical analysis relies on investor sentiment, errors in judgment, and historical price trends to predict future stock price movements.

Both behavioural finance and technical analysis assume that investors tend to act irrationally under certain circumstances. By identifying patterns of behaviour, opportunities for profits can be uncovered.

Technical analysts essentially search for bullish (positive) and bearish (negative) signals about stock prices or market direction.

Why is Technical analysis thriving? One possible reason is that investors can derive thousands of successful technical analysis systems by using historical security prices. This process is known as backtesting.

The Market Sentiment Index

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

• Believe that once 80% of the investors are bullish or bearish, a consensus has been reached.

• Maximum value of 1.00 (100%), which occurs when every investor you ask is bearish on the market

• Minimum value of 0.00 (0%), which occurs when every investor you ask is bullish on the market.

• When MSI is high, it is time to buy; when the MSI is low, it is time to go.

Dow Theory

Method that 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

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

Repeating stock price patterns, called “waves,” are collectively expressed as investor sentiment.

Technical Indicators

A support level is a price or level below which a stock or the market as a whole is unlikely to go.

A resistance level is a price or level above which a stock or the market as a whole is unlikely to rise.

Both are psychological barriers.

• Profit hunters help “support” the lower level

• Profit takers “resist” the upper level.

A Breakout occurs when a stock (or the market) passes through either a support or a resistance level.

Downward sloping advance/decline line shows a bearish signal.

Upward sloping line is a bullish signal.

“Closing arms” or Trin” (Trading index) is the ratio of average trading volume in declining issues to average trading volume in advancing issues.

Market Diaries are published by financial press daily. Shows the number of stocks that advanced and declined on an index each day.

Relative strength: Measures the performance of one investment relative to another.

Charting

Technical analysis is sometimes called “charting”.

Technical analyst are often called “Chartist.”

Chartist study graphs or past market prices or other info and try to identify particular patterns known as chart formations.

In Open-High-Low-Close charts, red bars indicate that the closing price was lower than the opening price.

In pricing channels, in a downward trend the upper trendline (resistance) is the main-treadline, and the lower trendline (support) is the channel-line. Flips when an upward trend.

In Head and Shoulders, once the neckline is pierced through, it signals a reversal pattern.

Reversal patterns are formations on charts that indicate sizeable changes in the direction of the market.

Head and shoulders Top:

• Sell signal when price falls through neckline

Head and shoulders Bottom:

• Buy signal when price rises through neckline

Moving Averages

Moving average charts are average daily prices or index levels, calculated using a fixed number of previous prices updated daily. Used to identify trends.

Fibonacci Numbers

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

If you take one number divided by previous number it will converge to 1.618 “Golden ratio” or “golden mean”.