Chapter 10 - Issues in Efficient Market
5. overreaction of the stock market
o Article by Werner DeBondt and Richard Thaler The journal of Finance title "Does the Stock Market Overreact." The beginning of behavioral finance, because it moved the topic from behavioral economics to finance • Investors systematically overreact to unexpected or dramatic events o Causes inefficiencies in the stock market • Includes both good and bad news • Winner/Loser Effect o Current bad performers tend to outperform good performers o Supported by arbitrage strategies
7. five basic assumptions of technical analysis
o Basic assumptions 1. Market value determined solely by interaction of demand and supply 2. Although there are minor fluctuations in the market, stock prices tend to move in trends that persist for long periods 3. Reversals of trends are caused by shifts in demand and supply 4. Shifts in demand and supply can be detected sooner or later in charts 5. Many chart patterns tend to repeat themselves o Most important stock prices tend to move in trends that persists for long periods of time and these trends can be detected in charts. The market technician assumes there is a lag between the time he perceives a change in the value of security and when the investing public assesses the change.
2. importance of heuristics (i.e., "rules of thumb")
o Definition - techniques for problem-solving that are based on experiential learning; these are often referred to as "rule of thumb." o Relies on the discovery and is used to come to an optimal solution o Nonreflective, intuitive, mechanisms for coping with complexity. o Adhere to social trends even if they are false o Psychologist Amos Tversky and Daniel Kahneman • Pioneers in the development of behavioral economics and finance
8. Dow Theory (major assumptions and central premise) and charting
o Dow Theory Definition - Maintains that there are three major movements in the market; daily fluctuations, secondary movements, and primary trends According to the theory daily fluctuations and secondary movements (cover two weeks to a month) are only important to the extent they reflect on the long-term primary trend in the market • This trend confirms that primarily trend which is bullish Under the Dow theory it is assumed that this pattern will continue on for a long time and should not be considered a secondary market. o Charting Linked to the development of the Dow Theory in 1890's by Charles Dow Signaled the market crash of 1929
10. point-and-figure charts
o Emphasizes significant price changes and the reversal of significant price changes o Has no time dimension o Chartists carefully read PFCs to observe market patterns: 1. Support 2. Resistance 3. breakouts 4. congestion, etc.
6. other behavioral issues: mental accounting (or framing), momentum investing, and herding
o Mental Accounting Where investors have a frame of reference that influence their decisions to buy/sell or hold. • Influence of framing in buy/sell/hold decisions o Momentum Investing Occurs when stock is moving in one direction in a consistent fashion • Investors tend to buy stocks that are going up • Buying pushes price higher causing "Momentum" o Herding Tendency of investors to copy each other's strategies • More prevalent among institutional investors • Follow the leader mentality
14. importance and use of the odd-lot theory
o Odd Lot Theory Look at what small investor is doing and do the opposite Characteristics • Less than 100 shares • Small investors Barron's reports them • Constructs a ratio of odd-lot purchases to odd lot sales o Ratio between .50 and 1.45 Pros and Cons • Does right most of the time but badly misses out on the market key terms • Strong seller right before the bottom of a bear market • Odd-lot trades on Mondays are particularly suspect o Investment Advisory Recommendations You should watch the predications of the investment advisory services and do the opposite • Investor intelligence: has formalized thin into an Index of Bearish Sentiment Rules • When 60% or more of the services expect a market upturn • When only 15% or fewer are bearish expect the decline of the market
4. prospect theory and the certainty theory
o Prospect Theory Alternative to utility theory it shows results that different from standard utility theory Investors do not use all available information when making decisions • Leads to inconsistent choices when provided with identical alternatives presented in different forms Investors tend to focus on gains and losses of individual investments • Utility Theory assumes an investor's focus is on total wealth creation instead of individual investment performance Explains why investors prefer certain or guaranteed outcomes over probable outcomes o Certainty Theory When the investors exhibit risk aversion by choosing sure gains rather than probable gains • Experiments found that investors also made risky choices when faced with a sure loss versus a probable loss that creates a gambling affect
12. essence of contrary opinion rules
o Rule: It is easier to figure out who is wrong than who is right Observe unsuccessful market behavior and choose a contrary position. o Odd Lot Theory Look at what small investor is doing and do the opposite Characteristics • Less than 100 shares • Small investors Barron's reports them • Constructs a ratio of odd-lot purchases to odd lot sales o Ratio between .50 and 1.45 Pros and Cons • Does right most of the time but badly misses out on the market key terms • Strong seller right before the bottom of a bear market • Odd-lot trades on Mondays are particularly suspect
15. Barron's Confidence Index (low versus high)
o Smart Money Rules Some investors attempt to track the pattern of sophisticated traders in the belief that they might provide superior investment results or unusual insight into the future. o Barron's Confidence Index Used to observe the trading pattern of investors in the bond market • Relies on belief that bond traders may be more sophisticated than stock traders • They may pick up trends more quickly The theory suggests that a person who can figure out what bond traders are doing today may be able to determine what stock market investors will be doing in the near future. • Computed by taking yield on 10 top-grade corporate bonds, dividing by yield on 40 intermediate-grade bonds, and multiplying by 100: Rules • As top-grade bonds pay smaller yields than intermediate-grade bonds, the Confidence Index is always below 100% • Normal trading range is between 80 and 96 • If bond investors are bullish about future economic prosperity, they are indifferent between holding top-grade and intermediate-grade bonds o The yield differences between the two categories will be relatively small
9. support and resistance levels
o Support Support may develop each time a stock goes down to a lower level of trading because investors who previously passed up a purchase opportunity may now choose to act • It is a signal that new demand is coming to the market Lower end of trading rangers o Resistance Resistance may develop when stock price rises to high side of normal trading range as investors take profit or try to get even after having bought at previous high • Upper ends of trading ranges o Breakout The security price moves out of a previous trading range (breaching the resistance or support level) suggesting a new consensus and new trading level. A breakout above a resistance level or below a support level is assumed to be significant • suggests that stock is now trading in new range • suggests higher or lower trading values outside the previous range may be expected
13. importance of bar charting/problems in reading and interpreting charts
o The problem Analyzing patterns in such a fashion that they truly predict stock markets movements before they unfold.
1. irrational market bubbles
o Tulip mania in Holland o Earliest Bubble o Charles Mackay book - Extraordinary Popular Delusions and the Madness of Crowd (1841) o Eventually the price of bulbs went down, and people were ruined o Florida Land Bubble (1920's) o In roaring 20's people flooded to Miami because it was considered a tropical paradise and speculators pushed the price up. o Credit was easy, and prices were inflated o Collapsed in 1925/26 after a few hurricanes and investors could not find buyers for their housing developments o Great stock market crash of 1929 and Depression followed o Similar to the financial crisis 2006-2008
3. three heuristics
o representativeness, availability, and anchoring-and-adjustment Representatives: People assess chances that an event will occur based on stereotypes Availability- People remember things that occur recently compared to those of the past Anchoring and adjustment - People estimate from existing or initial value then adjust for conclusion
