Investment Analysis - Chapter 12 (Module 5)

errors in information processing:

- forecasting errors - overconfidence - conservatism - sample size neglect and representativeness

house money effect

refers to gamblers' greater willingness to accept new bets if they currently are ahead. - They think of (i.e., frame) the bet as being made with their "winnings account," that is, with the casino's money rather than their own, and thus they are more willing to accept risk. - Analogously, after a stock market run-up, individuals may view investments as largely funded out of a "capital gains account," become more tolerant of risk, discount future cash flows at a lower rate, and thus further push up prices.

disposition effect

refers to the tendency of investors to hold on to losing investments. - can lead to momentum in stock prices even if fundamental values follow a random walk.

moving average of a stock price

the average price over a given interval, where that interval is updated as time passes. - For example, a 50-day moving average traces the average price over the previous 50 days. The average is recomputed each day by dropping the oldest observation and adding the newest. - After a period in which prices have been falling, the moving average will be above the current price (because the moving average continues to average in the older and higher prices until they leave the sample period). In contrast, when prices have been rising, the moving average will be below the current price. - Prices breaking through the moving average from below, are taken as a bullish signal, because this signifies a shift from a falling trend to a rising trend. - Conversely, when prices drop below the moving average, analysts might conclude that market momentum has become negative.

sentiment

the general level of optimism among investors.

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. -The ratio will always be below 1 because higher-rated bonds will offer lower promised yields to maturity.

The most common measure of breadth is:

the spread between the number of stocks that advance and decline in price. - If advances outnumber declines by a wide margin, then the market is viewed as being stronger because the rally is widespread.

Falling trend

prices below the moving average

Rising trend

Prices above the moving average.

put/call ratio

The ratio of outstanding put options to outstanding call options. -typically it hovers around 65%.

affect

a feeling of "good" or "bad" that consumers may attach to a potential purchase or investors to a stock.

Breadth of the market

a measure of the extent to which movement in a market index is reflected widely in the price movements of all the stocks in the market.

Mental accounting

a specific form of framing in which people segregate certain decisions. - can help explain momentum in stock prices

Behavioral finance

conventional financial theory ignores how real people make decisions and that people make a difference.

Call options

give investors the right to buy a stock at a fixed "exercise" price and therefore are a way of betting on stock price increases.

Put options

give the right to sell a stock at a fixed price and therefore are a way of betting on stock price decreases.

Representativeness bias

holds that people commonly do not take into account the size of a sample, acting as if a small sample is just as representative of a population as a large one.

trin statistic

is the ratio of average volume in declining issues to average volume in advancing issues. - = (volume declining/number declining) / (volume advancing/number advancing) - Ratios above 1.0 are considered bearish because the falling stocks would then have higher average volume than the advancing stocks, indicating net selling pressure.

Conservatism bias

means that investors are too slow (too conservative) in updating their beliefs in response to new evidence. - This means that they might initially underreact to news about a firm, so that prices will fully reflect new information only gradually.

relative strength

measures the extent to which a security has outperformed or underperformed either the market as a whole or its particular industry. - computed by calculating the ratio of the price of the security to a price index for the industry.

Prospect theory

modifies the analytic description of rational risk-averse investors found in standard financial theory.