CHAPTER 19

Behavioral Finance and Technical Analysis

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Behavioral Finance Traditional theory ignores some aspects

of personal behavior Behavioral finance tries to incorporate

personal behavior to extend corporate finance

Behavioral finance is a developing area

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Individual Behavior Cooperation and Altruism Bidding and the Winner’s Curse Endowment Effect, Status Quo Bias and

Loss Aversion Mental Accounts

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Asset Returns and Behavioral Explanations

Calendar effects Cash dividends Overreaction and mean reversion Controversial explanations from

behavioral finance– Closed-end fund pricing– Excess volatility in stock prices

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

High

Low

Close

Price

Days

Sample Price Chart

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

ooo o

oooo

ooo

oooo

oo

oo

Congestion areas

Sell

Point and Figure Chart

Price

x

x

x

x

x

x

xx

x

x

x

x

x

x

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Sentiment IndicatorsTrin Statistics

# Advancing / # DecliningVolume Advancing / Volume Declining

# Declining / Volume Declining# Advancing / Volume Advancing

If Trin > 1.0 bearish signal

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Sentiment Indicators Put / Call Ratio

– Historical value 65%– When higher than 65% a signal occurs

Bearish view Bullish view

Mutual Fund Cash Position– Cash levels are low - bearish sign– Cash levels are high - bullish sign

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Sentiment IndicatorsOdd - Lot Trading Ratio of odd-lot purchases to odd-lot

sales When ratio exceeds 1.0, bearish sign Contrarian logic - small investors are the

last to buy in bull markets

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Flow of Funds Indicators Short Interest - total number of shares that are

sold short– When short sales are high a signal occurs– Bullish interpretation– Bearish interpretation

Credit Balances in Brokerage Accounts– Investor leave balances when they plan to invest in

the future– When levels are high a bullish sign

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Market Structure IndicatorsMoving Averages Average price over some historical

period (5 weeks or 200 days) When current price crosses the average

a trading signal occurs Bullish signal when the current price

rises above the moving average Bearish sign when the current price falls

below the moving average

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Market Structure IndicatorsBreadth The extent to which movements in a

broad index are reflected widely in movements of individual stocks

Spread between advancing stocks and declining stocks

Also used in industry indexes

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Value Line System Widely followed with some evidence of

superior performance Value Line System is predominately a

technical system– Earnings momentum– Relative stock prices– Ratios of moving averages

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Value Line System Paper vs actual performance indicates

that the system is difficult to implement– Value Line Fund has not shown superior

performance– High turnover costs are associated with the

strategy Evidence shows prices react quickly to

reported ranking changes