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CHAPTER 8Behavioral Finance and the Psychology of InvestingChapter Sections:Introduction to Behavioral FinanceProspect TheoryOverconfidenceMisperceiving Randomness and Overreacting to Chance EventsSentiment-Based Risks and Limits to ArbitrageTechnical Analysis

“The investor’s 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 psycho’s? I prefer to call it Sly-chology

In 1962, there was a brief recession and a sharp market downturn, the President’s 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 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

(continued)

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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,

“It’s Different This Time” “It’s a New Era”

So did you pile into Apple or gold in 2011 and 2012?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 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 aren’t 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.

(continued)

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Common Investor Weaknesses 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/

(continued)

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Common Investor Weaknesses 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!

(continued)

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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 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 company’s capital structure How much debt, how much equity a.k.a. the “capitalization” of a company

(continued)

But there are many investors who don’t 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 price’s 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 company’s fundamental future outlook.

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Technical Analysis 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

(continued)

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 16,000, S&P 1,800, $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.cfmwww.stockmarketmentor.com/public/2335.cfm www.stockmarketmentor.com/public/4990.cfm

His top 10 trading rules are at 1609.cfm

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(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

Tools of Technical Analysis

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Tools of Technical Analysis 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

(continued)

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Tools of Technical Analysis(continued)

Dow Jones Industrial Average, January 2, 2001 to October 3, 2003

7,000

8,000

9,000

10,000

11,000

12,000

01/01 04/01 07/01 10/01 01/02 04/02 07/02 10/02 01/03 04/03 07/03 10/03

Date

Lev

el

The primary direction is either bullish or bearish, and reflects the long-run direction of the market.

Secondary trends,

temporary departures

Corrections, reversions to the primary direction

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Tools of Technical Analysis Relative Strength

Measure of the performance of one investment relative to another or to the market as a whole Recall The Value Line’s 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 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

(continued)

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Tools of Technical Analysis 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.

(continued)

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Tools of Technical Analysis 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.

(continued)

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Tools of Technical Analysis 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 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

(continued)

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Charting Examples Open-High-Low-Close Chart

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Charting Examples CandlestickChart

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Charting Examples CandlestickChart Formations

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Charting Examples Head-and-ShouldersChart

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Charting Examples AssortedCharts

Good Luck!

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You, Too, Can Be a Technical Analyst!

“The market’s 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

Next week: Chapter 9, Bonds – a.k.a. Fixed-Income Investments

Behavioral Finance and the Psychology of InvestingChapter Sections:Introduction to Behavioral FinanceProspect TheoryOverconfidenceMisperceiving Randomness and Overreacting to Chance EventsSentiment-Based Risks and Limits to ArbitrageTechnical Analysis