Professional Documents
Culture Documents
EIGN Lecture8
EIGN Lecture8
Portfolio Theory
Behavioral Finance,
Technical Analysis and Fusion
March 28th 2023
Final exam practicalities
• Date April 21st
• Time 9.00-12.00
• Overconfidence:
Investors overestimate their abilities and the precision of their
forecasts
• Conservatism:
Investors are slow to update their beliefs and underreact to new
information
• Mental Accounting
Investors may segregate accounts or monies and take risks with
their gains that they would not take with their principal
• Regret Avoidance
Investors blame themselves more when an unconventional or risky
bet turns out badly
Behavioural Biases: Examples
• Prospect Theory
Conventional view: Utility depends on level of wealth
Behavioural view: Utility depends on changes in current wealth
Limits to Arbitrage
• Behavioural biases would not matter if rational arbitrageurs could fully exploit the
mistakes of behavioural investors
• Fundamental Risk
John Maynard Keynes: “Markets can remain irrational longer than you
can remain solvent”
Intrinsic value and market value may take too long to converge
• Implementation Costs
Transactions costs and restrictions on short selling can limit arbitrage
activity
• Model Risk
What if you have a bad model and the market value is actually correct?
Limits to Arbitrage and the Law of One Price
• Siamese Twin Companies • Equity Carve-outs
• Royal Dutch should sell for 1.5xShell • 3Com and Palm
• Deviated from parity ratio for • Arbitrage limited by availability of
extended periods shares for shorting
• Example of fundamental risk
• Closed-End Funds
• May sell at premium or discount to
NAV
• Can also be explained by rational
return expectations
Bubbles and Behavioural Economics
• Bubbles are easier to spot after they end
• Dot-com bubble (Alan Greenspan: “irrational exuberance”)
• Housing bubble
• Rational explanation for stock market bubble using the dividend discount
model:
• Disposition effect
The tendency of investors to hold on to losing investments
Demand for shares depends on price history
Can lead to momentum in stock prices
Technical Analysis: Trends and Corrections
• Momentum and moving averages
• The moving average is the average level of prices over a given time interval, and the
interval updates as time passes.
• Moving averages work well in smoothing out fluctuations and highlight the direction
of a trend.
• Bullish signal:
Market price breaks through the moving average line from below, it is time to buy
• Bearish signal:
When prices fall below the moving average, it is time to sell
Moving Average for INTC
Technical Analysis: Relative Strength
• Relative strength
Measures if a security has out- or
underperformed either the market or its
industry
• Breadth
Often measured as the spread
between the number of stocks that
advance and decline in price
Technical Analysis: Sentiment Indicators
• Trin Statistic
• Confidence Index
• The ratio of the average yield on 10 top-rated corporate bonds divided by the
average yield on 10 intermediate-grade corporate bonds
• Higher values are bullish
Technical Analysis: Sentiment Indicators
• Put/Call Ratio
• Calls are the right to buy – a way to bet on rising prices
• Puts are the right to sell – a way to bet on falling prices
• A rising ratio may signal investor pessimism and a coming market decline
• Short interest
• The total number of shares of a stock currently sold short
• The common, bearish interpretation, would be a warning sign concerning the stock’s
prospects
• A less-common, bullish perspective is that, because all short sales must be covered the
short interest represents latent future demand for the stocks which will push prices up
Technical Analysis: A Warning
• William J . OʼNeil is one of the most influencial advocate for the Classical School
of Investing in the recent decades. He has emphasized the two-step investing of
always asking what stocks to buy and when to buy them.
• He was a pioneer about using computer power and digital database to apply
technical and fundamental analyses together for US stocks.
• In 1963 he started selling the service of his company to professional investors.
• Two decades later, in 1984, he broke a leaf in the history of the US stock market
when he started publishing integrated daily fundamental and technical analysis
data for all publicly traded US companies in the newspaper Investor’s Business
Daily (IBD). Hence making the information available to individual investors.
Investor´s Business Daily
William O´Neil
Next
March 30th – the last problem-solving session
April 21st – final exam