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2 categories of irrationalities
- information processing: thus deriving incorrect probability dist
- behavioral bias: implying inconsistent/suboptimal decisions
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Information processing irrationalities
- forecasting errors: too much weight to recent, too extreme forecast given uncertainty
- overconfidence
- sample size neglect & representativeness: don't account for sample size
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Behavioral biases irrationalities
- framing: decision impacted by how it's framed
- mental accounting: segregating decisions
- regret avoidance: more regret if loss due to unconventional decision
- prospect theory: utility depends on change in wealth
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Behavioral finance - limits to arbitrage
- fundamental risk: actions not risk free, mispricing could get worse
- implementation cost: might be asked to return short selled asset, some can't short sell
- model risk: prices could indeed be valid
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Known violations of law of one price
- siamese twin cpies: split profits 60/40 but stock price didn't follow. Arbitrageurs lost money because deviations grew
- equity carve-outs: close Palm, pay 1.5 share. Stock relativity was below 1, but no shares available
- closed-end funds: usually trade for disc/prem but can be explained (expenses)
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Behavioral critique
- too unstructured: allows virtually all anomalies to be explained
- inconsistent anomalies
- wrong benchmark selection could cause apparent misprice
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Behavioral finance - technical analysis
- disposition effect: investors hold on to losing investments
- volume data: overconfident trade more -> relationship btwn trade vol & return
- mkt fundamentals will be disturbed by irrational factors
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Behavioral finance - trends & corrections
- Dow theory: primary/intermediate/minor trends
- Moving average: break from below = bullish (decr to incr)
- Breadth: spread btwn # incr vs decr stocks. If # incr way above decr = strong
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Mkt sentiment indicators
- trin statistic: (vol / # decr) / (vol / # incr). Above 1 = bearish
- confidence index: yield top 10 corp bds / intermediate. Close to 1 = strong
- Put/Call ratio: incr in ratio indicates bearish mkt
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