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
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.
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
Chapter 12 – Behavioral Finance and Technical Analysis
12-2
4. There are two reasons why behavioral biases might not affect equilibrium asset
prices: first, behavioral biases might contribute to the success of technical trading
rules as prices gradually adjust towards their intrinsic values, and second, the
5. Efficient market advocates believe that publicly available information (and, for
advocates of strong-form efficiency, even insider information) is, at any point in
time, reflected in securities prices, and that price adjustments to new information
6. a. Davis uses loss aversion as the basis for her decision making. She holds on to
stocks that are down from the purchase price in the hopes that they will recover.
She is reluctant to accept a loss.
7. a. Shrum refuses to follow a stock after she sells it because she does not want to
8. a. Investors attempt to avoid regret by holding on to losers hoping the stocks will
Chapter 12 – Behavioral Finance and Technical Analysis
12-3
9. a. iv
b. iii
10. Underlying risks still exist even during a mispricing event. The market mispricing
11. Data mining is the process by which patterns are pulled from data. Technical
12. Even if prices follow a random walk, the existence of irrational investors combined
with the limits to arbitrage by arbitrageurs may allow persistent mispricings to be
14. Breadth:
15. This exercise is left to the student; answers will vary, but successful students should
16. The confidence index increases from (5%/6%) = 0.833 to (6%/7%) = 0.857.
Chapter 12 – Behavioral Finance and Technical Analysis
12-4
17. At the beginning of the period, the price of Computers, Inc. divided by the industry
index was 0.39; by the end of the period, the ratio had increased to 0.50. As the
18. Five day moving averages:
Days 1 – 5: (19.63 + 20 + 20.5 + 22 + 21.13) / 5 = 20.65
Days 2 – 6 = 21.13
Days 3 – 7 = 21.50
Days 16 – 20 = 19.05
Days 17 – 21 = 18.93 Buy signal (day 21 price > moving average)
Days 18 – 22 = 19.28
Days 19 – 23 = 19.93
Days 20 – 24 = 21.05
Days 21 – 25 = 22.05
Chapter 12 – Behavioral Finance and Technical Analysis
12-5
19. This pattern shows a lack of breadth. Even though the index is up, more stocks
declined than advanced, which indicates a “lack of broad–based support” for the rise
in the index.
20.
Day
Advances
Declines
Net
Advances
Cumulative
Breadth
1
906
704
202
202
2
653
986
-333
-131
4
503
968
-465
-664
5
497
-598
-1,262
6
970
702
268
-994
7
609
393
-601
8
903
722
181
-420
9
850
748
102
-318
766
766
-318
21. Trin =
936.0
906/million 330
704/million 240
advancing Number/advancing Volume
declining Number/declining Volume ==
Chapter 12 – Behavioral Finance and Technical Analysis
12-6
23. Note: In order to create the 26-week moving average for the S&P 500, we
converted the weekly returns to weekly index values, with a base of 100 for the
week prior to the first week of the data set. The following graph shows the S&P 500
values and the 26-week moving average, beginning with the 26th week of the data
set.
a. The graph summarizes the data for the 26-week moving average. The graph
also shows the values of the S&P 500 index.
b. The S&P 500 crosses through its moving average from below 14 times, as
indicated in the table below. The index increases seven times in weeks
following a cross-through and decreases seven times.
Date of
Cross-Through
Direction of S&P 500
in Subsequent Week
05/18/01
Decrease
06/08/01
Decrease
12/07/01
Decrease
12/21/01
03/01/02
11/22/02
01/03/03
03/21/03
Decrease
04/17/03
06/10/04
Decrease
09/03/04
10/01/04
Decrease
10/29/04
Chapter 12 – Behavioral Finance and Technical Analysis
12-7
04/08/05
Decrease
c. The S&P 500 crosses through its moving average from above 14 times, as
indicated in the table below. The index increases nine times in weeks
following a cross-through and decreases five times.
Date of
Cross-
Through
Direction of S&P
500 in Subsequent
Week
Date of
Cross-
Through
Direction of S&P
500 in Subsequent
Week
03/28/03
04/30/04
07/02/04
09/24/04
10/15/04
03/24/05
04/15/05
d. When the index crosses through its moving average from below, as in part
(b), this is regarded as a bullish signal. In our sample, the index is as likely to
24. In order to create the relative strength measure, we converted the weekly returns for
the Fidelity Banking Fund and for the S&P 500 to weekly index values, using a
Chapter 12 – Behavioral Finance and Technical Analysis
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b. Over five-week intervals, relative strength increased by more than 5% 29
times, as indicated in the table and graph below. The Fidelity Banking Fund
underperformed the S&P 500 index 18 times and outperformed the S&P 500
index 11 times in weeks following an increase of more than 5%.
Date of
Increase
Performance of
Banking Fund in
Subsequent Week
Date of
Increase
Performance of
Banking Fund in
Subsequent Week
07/21/00
Outperformed
03/09/01
Outperformed
08/04/00
Outperformed
03/16/01
Underperformed
08/11/00
Underperformed
03/30/01
Underperformed
08/18/00
Outperformed
06/22/01
Underperformed
09/22/00
Outperformed
08/17/01
Underperformed
09/29/00
Underperformed
03/15/02
Outperformed
10/06/00
Underperformed
03/22/02
Underperformed
12/01/00
Underperformed
03/28/02
Outperformed
12/22/00
Underperformed
04/05/02
Outperformed
12/29/00
Outperformed
04/12/02
Underperformed
01/05/01
Underperformed
04/26/02
Outperformed
01/12/01
Underperformed
05/03/02
Underperformed
02/16/01
Underperformed
05/10/02
Underperformed
02/23/01
Outperformed
06/28/02
Underperformed
03/02/01
Underperformed
Chapter 12 – Behavioral Finance and Technical Analysis
c. Over five-week intervals, relative strength decreases by more than 5% 15
times, as indicated in the graph above and table below. The Fidelity Banking
Fund underperformed the S&P 500 index six times and outperformed the S&P
500 index nine times in weeks following a decrease of more than 5%.
Date of
Decrease
Performance of
Banking Fund in
Subsequent Week
Date of
Decrease
Performance of
Banking Fund in
Subsequent Week
07/07/00
Underperformed
04/16/04
Underperformed
07/14/00
04/23/04
05/04/01
Underperformed
12/03/04
05/11/01
12/10/04
Underperformed
10/12/01
12/17/04
11/02/01
12/23/04
Underperformed
10/04/02
12/31/04
Underperformed
10/11/02
d. An increase in relative strength, as in part (b) above, is regarded as a bullish
signal. However, in our sample, the Fidelity Banking Fund is more likely to
Chapter 12 – Behavioral Finance and Technical Analysis
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25. It has been shown that discrepancies of price from net asset value in closed-end funds
CFA PROBLEMS
1. i. Mental accounting is best illustrated by Statement #3. Sampson’s requirement
that his income needs be met via interest income and stock dividends is an
example of mental accounting. Mental accounting holds that investors
segregate funds into mental accounts (e.g., dividends and capital gains),
maintain a set of separate mental accounts, and do not combine outcomes; a
2. a. Frost’s statement is an example of reference dependence. His inclination to sell
the international investments once prices return to the original cost depends not
only on the terminal wealth value, but also on where he is now, that is, his
reference point. This reference point, which is below the original cost, has
Chapter 12 – Behavioral Finance and Technical Analysis
12–11
XYZ, Frost is also exemplifying the behavioral finance phenomenon of asset
segregation. That is, he is evaluating Country XYZ investment in terms of its
anticipated gains or losses viewed in isolation.
Individuals are typically more confident about the validity of their conclusions
c. Frost’s statement is an example of mental accounting. Mental accounting
holds that investors segregate money into mental accounts (e.g., safe versus
speculative), maintain a set of separate mental accounts, and do not combine
outcomes; a loss in one account is treated separately from a loss in another
account. One manifestation of mental accounting, in which Frost is engaging,
is building a portfolio as a pyramid of assets, layer by layer, with the
3. a. Illusion of knowledge: Maclin believes he is an expert on, and can make
accurate forecasts about, the real estate market solely because he has studied
housing market data on the Internet. He may have access to a large amount of
Chapter 12 – Behavioral Finance and Technical Analysis
12–12
estate-related information he has collected, although there is no information in the
question that suggests he possesses such ability.
b. Reference point: Maclin’s reference point for his bond position is the purchase
price, as evidenced by the fact that he will not sell a position for less than he
c. Familiarity: Maclin is evaluating his holding of company stock based on his
familiarity with the company rather than on sound investment and portfolio
principles. Company employees, because of this familiarity, may have a
4. a. The behavioral finance principle of biased expectations/overconfidence is most
consistent with the investor’s first statement. Petrie stock provides a level of
confidence and comfort for the investor because of the circumstances in which she
her portfolio (she is retired) and the brevity of the recent performance history.
b. The behavioral finance principle of mental accounting is most consistent with
the investor’s second statement. The investor has segregated the monies
Chapter 12 – Behavioral Finance and Technical Analysis
5. i. Overconfidence (Biased Expectations and Illusion of Control): Pierce is basing
her investment strategy for supporting her parents on her confidence in the
economic forecasts. This is a cognitive error reflecting overconfidence in the form
of both biased expectations and an illusion of control. Pierce is likely more
confident in the validity of those forecasts than is justified by the accuracy of
ii. Loss Aversion (Risk Seeking): Pierce is exhibiting risk aversion in deciding to sell
the Core Bond Fund despite its gains and favorable prospects. She prefers a certain
gain over a possibly larger gain coupled with a smaller chance of a loss. Pierce is
exhibiting loss aversion (risk seeking) by holding the High Yield Bond Fund
despite its uncertain prospects. She prefers the modest possibility of recovery
iii. Reference Dependence: Pierce’s inclination to sell her Small Company Fund
once it returns to her original cost is an example of reference dependence.
This is predicated on the current value as related to original cost, her reference