Chapter 9
Behavioral Finance and Technical Analysis

The effiecient market hypothesis makes two important predictions. First, it implies that security prices properly reflect whatever information is available to investors. Second, active traders will find it difficult to outperform passive strategies such as holding market indexes. A relatively new school of thought dubbed behavioral finance argues that sprawling literature on trading strategies has missed a larger and more important point by overlooking the first implication of efficient markets-the correctness of security prices. Behavioral finance are models that emphasize potential implications of psychological factors affecting investor behavior. Its premise is that conventional financial theory ignores how real people make decisions and that people make a difference. A growing number of economists have come to interpret the anomalies literature as consistent with several “irrationalities” that seem to characterize individuals making complicated decisions.
2 Broad Categories: 1. Investors do not always process information correctly and therefore infer incorrect probability distributions about furture rates of return. 2. Even given a probability distribution of returns, they often make inconsistent or systematically suboptimal decisions.

Information Processing Errors in information processing can lead investors to misestimate the true probabilities of possible events or associated rates of return.
Forecasting errors
People give too much weight to recent experience compared to prior beliefs when making forecasts (memory bias) and tend to make forecasts that are too extreme given the uncertainty inherent in their information. (Kahneman and Tversky, (1972, 1973)). High P/E firms tend to be poor investments. (De Bondt and Thaler (1990))
Overconfidence
People tend to overestimate the precision of their beliefs or forecasts, and they tend to overestimate their abilities. Such overconfidence may be responsible for the prevalence of active versus passive investment management-itself an anomaly to adherents of the efficient market hypothesis. The dominant of active management in the face of the typical underperformance of such strategies is consistent with a tendency to overestimate ability.
Conservatism
A 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 underact to news about a firm, so that prices will fully reflect new information only gradually. Such bias would give rise to momentum in stock market returns.
Sample size neglect and representatives
Representativeness holds that people commonly do not take into account the size of sample, apparently reasoning that a small sample is just as representative of a population as a large one. People are too prone to believe that a small sample is representative of a broad population and infer patterns too quickly.

Behavioral Biases
Many studies conclude that individuals would tend to make less-than-fully rational decisions using the information. These largely affect how investors frame questions of risk versus return, and therefore make risk-return trade-offs.
Framing
Decisions are affected by how choices are posed. In other words, individuals may act risk averse in terms of gains but risk seeking in terms of losses. But in many cases, the choice of how to frame a risky venture - as involving gains or losses – can be arbitrary.

Mental accounting
Mental accounting is a specific form of framing in which people segregate certain decisions. Mental accounting effects also can help explain momentum in stock prices. The house money effect refers to gamblers’ greater willingness to accept new bets if they currently are ahead.

Regret avoidance
People blame themselves more for unconventional choices that turn out badly so they avoid regret by making conventional decisions. It is consistent with both the size and book-to-market effect. Such firms require more “courage” on the part of investor, which increases the required rate of return.
Prospect theory
Prospect theory modifies the analytic description of rational risk-averse investors found in standard financial theory. It is a behavioral theory that investor utility depends on gains or losses from starting position, rather than on their levels of wealth.