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Behavioral Critique
- Conventional financial theory ignores how people really make decisions under uncertainty
- People commonly make errors inferring prob dist
- People often make suboptimal decisions
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Examples of Information Processing Errors
- Forecasting errors: too much weight to recent evidence
- Overconfidence in estimation of returns
- Sample size neglect and representativeness: people tend to infer patterns from limited information
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Examples of Behavioral Biases
- Framing: seek gain but avoid losses
- Mental accounting: using "your" money vs using gains
- Regret avoidance: shy away from out of favor stocks
- Prospect theory: instead of defining utility based on wealth, we use change in wealth
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3 factors that reduce arbitrage opportunities
- Fundamental risk: even true assumption about price violation can require long-term investment w/ potential losses before gains
- Implementation cost: for example transaction costs
- Model risk: always a possibility that your model is wrong
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3 examples of Law of One Price violation
- Siamese twin companies: 2 merging companies agreed on a 60/40 profit split, but stock prices were not exactly adjusted
- Equity carve outs: volume of stocks and short selling trend can make it barely impossible to actually short sale
- Closed-end funds: mkt value of closed-end mutual funds shares reflect a substantial discount from the net asset value
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3 methods to identify trend
- Dow theory: stock prices are driven by (a) primary trends (long term movement), (b) secondary trends (intermediate term), and (c) minor trends (daily fluctuations)
- Moving average: smooth out short-term fluctuations to make it easier to spot chg in trends
- Breadth: compare nb of winners and losers
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3 tools to capture change in investor sentiment
- Trin statistics: ratio of avg declining to rising stocks
- Confidence index: ratio of high grade corporate bond yield to intermediate grade corporate bond yield
- Put/Call ratio: hovers around 0.65
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