V-601-EIGN

Portfolio Theory
Behavioral Finance,
Technical Analysis and Fusion
March 28th 2023
Final exam practicalities
• Date April 21st
• Time 9.00-12.00

• Open book exam to be completed at home

• Multiple choice exam in Canvas - Quizzes
• Also excel calculation scratch paper turned in a drop folder in Canvas – Assignments
• If there are information that I need to get to you during the exam that will be published in
Canvas – Announcements
• If you have questions during the final exam, you can send an email or call
• Those entitled to longer exam times will be provided with longer time
Behavioural finance and technical analysis
• Conventional theories presume that investors are rational but behavioral finance
starts with the assumption that they are not.

• Information processing and behavioural irrationalities.

• Limits to arbitrage and bubbles in behavioural economics.

• Technical analysis and strategies.

Conventional vs. Behavioural Finance

Conventional Finance Behavioural Finance

• Prices are correct and equal to • What if investors don’t behave
intrinsic value rationally?
• Resources are allocated efficiently
• Consistent with EMH
The Behavioural Critique
Two categories of irrationalities
1. Investors do not always process information correctly
Result: Incorrect probability distributions of future returns

2. Even when given a probability distribution of returns, investors may make

inconsistent or suboptimal decisions
Result: They have behavioural biases
Errors in Information Processing
• Forecasting Errors:
Too much weight is placed on recent experiences

• Overconfidence:
Investors overestimate their abilities and the precision of their
forecasts

• Conservatism:
Investors are slow to update their beliefs and underreact to new
information

• Sample Size Neglect and Representativeness:

Investors are too quick to infer a pattern or trend from a small sample
Behavioural Biases: Examples
• Framing
How the risk is described, “risky losses” vs. “risky gains” can affect
investor decisions

• 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:

• S&P 500 is worth $12,883 million if dividend growth rate is 8%

• Close to actual value in 2000

• S&P 500 is worth $8,589 million if dividend growth rate is 7.4%

• Close to actual value in 2002
Technical Analysis and Behavioural Finance
• Technical analysis attempts to exploit recurring and predictable patterns in
stock prices
Prices adjust gradually to a new equilibrium
Market values and intrinsic values converge slowly

• 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

Pricing ratio implies outperformance

• Breadth
Often measured as the spread
between the number of stocks that
advance and decline in price
Technical Analysis: Sentiment Indicators
• Trin Statistic

• Ratios above 1.0 are bearish indicating net selling pressure

• 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

• It is possible to perceive patterns that aren’t there.

• A problem related to that tendency is data mining.
• A crucial question is whether there is reason to believe that
what worked in the past should continue to work in the
future.
Technical analysis of securities receives formal
status in the 1930’s
• Richard Schabacker published three books in 1930 to ’35, thus formalizing
technical analysis as a formal school of investment analysis.
• Robert D. Edwards and John Magee build on Schabackers work.
Fusion of fundamental and technical analysis

Fundamental analysis assesses the intrinsic value of a stock or asset by studying

the earnings reports, economy and industry among other things.
Technical analysis focuses on identifying trends and patterns that can help
understand how a stock may perform in the future.
Fundamental and technical analysis can be combined to provide a comprehensive
trading strategy.
The focus is often on comparing the differences between fundamental and
technical analysis, but by fusing the two it can have overwhelmingly positive
benefits.
William O´Neil

• 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, the

founder of IBD Investor
´s Business Daily in Los
Angeles in 1984.

William O’Neil revolutionizes investors access to 21st century stock

analysis by fully integrating market timing and fundamental research.
“All stocks are bad….

• …unless they go up in price. “

• “If they go down instead, cut your losses fast. Letting losses run is the most
serious mistake made by most investors.”
• “The number one market leader is not the largest company or the one with the
most recognized brand name; it’s the one with the best quarterly and annual
earnings growth, return on equity, profit margins, sales growth, and price
action.”

William O´Neil
Next
March 30th – the last problem-solving session
April 21st – final exam