Stock Price Behavior and Market Effeciency

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CHAPTER 8
Behavioral Finance and the Psychology of Investing
Chapter Sections Introduction to Behavioral
Finance Prospect Theory Overconfidence Misperceivi
ng Randomness and Overreacting to Chance
Events Sentiment-Based Risks and Limits to
Arbitrage Technical Analysis
The investors chief problem, and even his worst
enemy, is likely to be himself. Benjamin Graham
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Investor Psychology

• Investor what?!
• Psycho-logy The study of psychos?
• I prefer to call it Sly-chology

In 1962, there was a brief recession and a sharp
market downturn, the Presidents chief economic
adviser was giving a presentation to many of the
political and economic leaders of the time,
describing what they were doing to right the
economy. One of the attendees asked, So when is
the stock market going to recover? The adviser
curtly responded, I am an economist, Sir, not a
psychiatrist.
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Investor Psychology
(continued)

• Because of the tremendous amount of money
  involved in the markets,
• Much research has gone into trying to understand
  investor psychology
• Some of the research is very revealing about who
  and what we are
• Not only as investors but also as a species in
  general

There are three factors that influence the
markets Fear, Greed, and Greed. Old Wall
Street saying
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Common Investor Weaknesses

• Reading too much into the recent past
• Beware the Permanent Trend
• Even though there are countless examples of
  investors getting on the bandwagon just as the
  wagon was about to veer into a ravine,
• We trick ourselves into believing that,
• Its Different This Time
• Its a New Era

So are you piling into gold and Treasury bonds
now? Did you buy oil in mid-2008? How did that
condo conversion flipper in early-2006 work
out? How about eToys, TheGlobe.com, or CMGI in
1999?
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Common Investor Weaknesses
(continued)

• Misperceiving randomness
• Even though stock price movements in the short
  term are random, our brains will trick us into
  seeing a pattern
• We humans are heuristic we look for patterns
• Even if we know that there arent any to be found
• In a series of a million random digits, the
  probability that one digit will be repeated 13
  times in a row is essentially 100

In my humble opinion, Technical Analysts are
guilty of this failing. We will discuss
Technical Analysis soon.
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Common Investor Weaknesses
(continued)

• Being overconfident
• Believing you know more that you think you know,
  or
• Believing you are better than most other
  investors
• The truth is we only see the tip of the iceberg
  with regard to what is happening within a
  company, an industry, and the economy
• And we are usually only average or mediocre
  investors at best
• Especially if we decide to become traders!

Are you an excellent, good, average, fair, or
poor driver? The Lake Woebegone Effect.
http//prairiehome.publicradio.org/
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Common Investor Weaknesses
(continued)

• Selling your winners too soon and hanging on to
  your losers (a.k.a. loss aversion)
• As humans, we hate to admit we made a mistake, so
  we stubbornly hold onto our losers, hoping that
  they will at least get back to where we bought in
• The reality is that our memories are wired to
  forget unpleasant experiences
• Sell our losers and we will quickly forget about
  them
• Hang onto them and we will always be reminded of
  our stupidity

In contrast, hanging onto the winners is what
makes an investor rich. So hang onto your
winners!
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Fundamental Analysis

• Fundamental Analysis (review)
• The in-depth study of the financial condition and
  operating results of a firm
• A method of evaluating securities by attempting
  to measure the intrinsic value of a particular
  stock. Fundamental analysts study everything from
  the overall economy and
  industry conditions, to the financial condition
  and management of companies

Simply put, the value of a stock is influenced by
the performance of the company that issued the
stock. The valuation models from Chapter 6 that
we covered have all used fundamental analysis.
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Fundamental Analysis
(continued)

• Some of the Fundamentals (review)
• The competitive position of the company
• Do not forget to research their competitors!
• Its composition and growth in sales and earnings
• Profit margins and the dynamics of company
  earnings
• The composition and liquidity of corporate
  resources
• What assets are available
• The companys capital structure
• How much debt, how much equity
• a.k.a. the capitalization of a company

But there are many investors who dont follow the
Fundamentals.
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Technical Analysis

• Technical Analysis
• The study of the various forces at work in the
  marketplace and their effect on stock prices
• Those who adhere to technical analysis believe
  that they can predict the future price of a stock
  by analyzing the behavior of the stock prices
  history and/or the overall stock market
• Or any one or many of dozens of so-called
  Technical Indicators

Simply put, the future price of a stock is
influenced by factors other than the companys
fundamental future outlook.
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Technical Analysis
(continued)

• Argument in favor of Technical Analysis
• Stock prices do tend to move in tandem to the
  stock market as a whole
• When the market is rising, most stocks rise with
  it
• A rising tide lifts all boats
• When the market is falling, most stocks are
  brought down with it
• Rebuttal
• But that is just supply and demand at work
• When stocks are in favor, prices rise
• When stocks become out of favor, prices fall

Repeat after me There has never been a reliable
methodology for predicting the short-term
behavior of the stock market.
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Tools of Technical Analysis

• Market Prices
• Momentum buying
• The Trend is Your Friend
• Support level versus Resistance level
• Support level price or level below which a
  stock or the market as a whole is unlikely to
  fall
• Resistance level price or level above which a
  stock or the market as a whole is unlikely to
  rise
• Psychological barriers
• Dow 13,000, SP 1,500, 100 for a stock, etc.
• Moving average
• An average price or index level, calculated using
  a fixed number of previous days prices or levels
• 50-day, 200-day, etc. moving average

Examples www.stockmarketmentor.com/public/607.cf
m www.stockmarketmentor.com/public/2335.cfm His
top 10 trading rules are at 1609.cfm
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Tools of Technical Analysis
(continued)

• A technical trader follows the 50-day 200-day
  moving averages
• If the 50-day crosses the 200-day from above, it
  is a bearish signal
• If the 50-day crosses the 200-day from below, it
  is a bullish signal

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Tools of Technical Analysis
(continued)

• The Dow Theory
• One of the more historically popular price
  movement technical theories
• Uses both the Dow Jones Industrial Average
  (a.k.a. the Dow) and the Dow Jones Transports
  Average
• The Dow theory tries to identify three forces
• a primary direction or trend,
• a secondary reaction or trend, and
• daily fluctuations
• By watching the changes in the primary and
  secondary directions of the indexes, you are
  supposed to be able to determine the overall
  direction of the market

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Tools of Technical Analysis
(continued)
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Tools of Technical Analysis
(continued)

• Relative Strength
• Measure of the performance of one investment
  relative to another or to the market as a whole
• Recall The Value Lines Relative Strength
  indicator
• Market Volume
• Heavy volume versus low volume
• Heavy volume with prices rising is (supposed to
  be) good
• Low volume with prices falling is (supposed to
  be) good
• Heavy volume with prices falling is (supposed to
  be) bad
• Low volume with prices rising is (supposed to be)
  bad

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Tools of Technical Analysis
(continued)

• Breadth of the Market
• The Advance/Decline Ratio
• How many stocks went up, how many went down
• When the mood of investors is bullish, the
  advance/decline ratio should rise
• Advancing issues will outnumber declining issues
• When the mood of investors is bearish, the
  advance/decline ratio should fall
• Declining issues will outnumber advancing issues
• The Tick
• The trade-by-trade direction of the market
• Up Tick, Down Tick
• Opening Tick, Closing Tick
• Bullish Tick, Bearish Tick

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Tools of Technical Analysis
(continued)

• Short Interest
• The number of stocks sold short in the market at
  any given time
• The more stocks are sold short, the more
  investors believe the market will fall
• For some reason, short investors are somehow
  considered more sophisticated and are therefore
  supposed to know when the market will fall
• But when large numbers of investors sell short,
  eventually they must buy the shares back
• This creates a pent up demand for stocks

A large amount of short interest is like a
compressed spring. Eventually, there will be a
short squeeze and prices will rise.
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Tools of Technical Analysis
(continued)

• Odd-lot Trading
• Theory based on the idea that small investors
  tend to buy and sell in odd lots
• Recall An odd lot is less than 100 shares
• The best thing to do is the opposite of what
  small investors are doing
• If old-lot trading rises, it supposedly means
  that more and more small investors are entering
  the market
• Small investors are supposedly notorious for
  getting into the market at the top of a bull
  market

The research and data behind this theory are very
suspect. Plus technology has made odd-lot
trading commonplace.
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Tools of Technical Analysis
(continued)

• Contrarian Opinion
• The theory that if people are very optimistic,
  that is a predictor of falling prices for the
  market, and
• If people are very pessimistic, that is a
  predictor of rising prices
• Therefore, we all should be as bearish as
  possible and that will make the market rise,
  right?!
• We covered Contrarian Strategy already in
  Investment Strategies
• Buy when others are selling
• Sell when others are buying
• The problem is the market historically has gone
  up three times more than it goes down

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Tools of Technical Analysis
(continued)

• Charting
• The activity of charting price behavior and other
  market information and then using the patterns
  these charts form to make investment decisions
• Hi-lo-close charts candlestick charts
• Bar charts adapted to stocks and other
  investments
• Chart formations
• Resistance and support levels Breakout!
• Head and shoulders
• Triangles
• Flag and pennant
• Cup and saucer

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Charting Examples
Open-High-Low-Close Chart
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Charting Examples
Candlestick Chart
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Charting Examples
Candlestick Chart Formations
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Charting Examples
Head-and-Shoulders Chart
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Charting Examples
Assorted Charts
Good Luck!
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You, Too, Can Be a Technical Analyst!
The markets rise after a period of
reaccumulation is a bullish sign. Nevertheless,
fulcrum characteristics are not yet clearly
present and a resistance area exists 40 points
higher in the Dow, so it is clearly premature to
say the next leg of the bull market is up. If,
in the coming weeks, a test of the lows holds and
the market breaks out of its flag, a further rise
would be indicated. Should the lows be violated,
a continuation of the intermediate term downward
trend is called for. In view of the current
situation, it is a distinct possibility that
traders will sit in the wings awaiting a clearer
delineation of the trend and the market will move
in a narrow trading range.
I think it means, If the market does not go up
or down, it will remain unchanged.
Translation?
A Random Walk Down Wall Street
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Careers in Stocks

• Registered Representative
• a.k.a. Stockbroker, Financial Representative,
  Account Executive, Financial Planner
• Background check
• No shenanigans with other peoples money
• Must take Series 7 and Series 66
• Series 7 is difficult, 6 hours, 2 months of
  studying
• Series 66 is much easier, 2 to 4 weeks study
• Must be sponsored by a brokerage firm
• Some brokerages exist simply to sponsor people
• Expect to pay a fee to them for the privilege of
  being sponsored
• Many brokerages now sponsoring new recruits!

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CHAPTER 8 REVIEW
Behavioral Finance and the Psychology of Investing
Chapter Sections Introduction to Behavioral
Finance Prospect Theory Overconfidence Misperceivi
ng Randomness and Overreacting to Chance
Events Sentiment-Based Risks and Limits to
Arbitrage Technical Analysis
Next week Chapter 9, Bonds a.k.a. Fixed-Income
Investments