CHAPTER 12: BEHAVIORAL FINANCE AND TECHNICAL ANALYSIS
CHAPTER 12: BEHAVIORAL FINANCE
AND TECHNICAL ANALYSIS
PROBLEM SETS
1. Technical analysis can generally be viewed as a search for trends or patterns in market prices. Technical analysts tend to view these trends as momentum, or gradual adjustments to ‘correct’ prices, or, alternatively, reversals of trends. A number of the behavioral biases discussed in the chapter might contribute to such trends and patterns. For example, a conservatism bias might contribute to a trend in prices as investors gradually take new information into account, resulting in gradual adjustment of prices towards their fundamental values. Another example derives from the concept of representativeness, which leads investors to inappropriately conclude, on the basis of a small sample of data, that a pattern has been established that will continue well into the future. When investors subsequently become aware of the fact that prices have overreacted, corrections reverse the initial erroneous trend.
2. Even if many investors exhibit behavioral biases, security prices might still be set efficiently if the actions of arbitrageurs move prices to their intrinsic values. Arbitrageurs who observe mispricing in the securities markets would buy underpriced securities (or possibly sell short overpriced securities) in order to profit from the anticipated subsequent changes as prices move to their intrinsic values. Consequently, securities prices would still exhibit the characteristics of an efficient market.
3. One of the major factors limiting the ability of rational investors to take advantage of any ‘pricing errors’ that result from the actions of behavioral investors is the fact that a mispricing can get worse over time. An example of this fundamental risk is the apparent ongoing overpricing of the NASDAQ index in the late 1990s. A related factor is the inherent costs and limits related to short selling, which restrict the extent to which arbitrage can force overpriced
AND TECHNICAL ANALYSIS
PROBLEM SETS
1. Technical analysis can generally be viewed as a search for trends or patterns in market prices. Technical analysts tend to view these trends as momentum, or gradual adjustments to ‘correct’ prices, or, alternatively, reversals of trends. A number of the behavioral biases discussed in the chapter might contribute to such trends and patterns. For example, a conservatism bias might contribute to a trend in prices as investors gradually take new information into account, resulting in gradual adjustment of prices towards their fundamental values. Another example derives from the concept of representativeness, which leads investors to inappropriately conclude, on the basis of a small sample of data, that a pattern has been established that will continue well into the future. When investors subsequently become aware of the fact that prices have overreacted, corrections reverse the initial erroneous trend.
2. Even if many investors exhibit behavioral biases, security prices might still be set efficiently if the actions of arbitrageurs move prices to their intrinsic values. Arbitrageurs who observe mispricing in the securities markets would buy underpriced securities (or possibly sell short overpriced securities) in order to profit from the anticipated subsequent changes as prices move to their intrinsic values. Consequently, securities prices would still exhibit the characteristics of an efficient market.
3. One of the major factors limiting the ability of rational investors to take advantage of any ‘pricing errors’ that result from the actions of behavioral investors is the fact that a mispricing can get worse over time. An example of this fundamental risk is the apparent ongoing overpricing of the NASDAQ index in the late 1990s. A related factor is the inherent costs and limits related to short selling, which restrict the extent to which arbitrage can force overpriced