Lessons from Behavioral Finance
Stockscores.com Perspectives for the week ending July 21, 2014
In this week's issue:
In This Week's Issue:
- Stockscores' Market Minutes Video - Investor Motivation
- Stockscores Trader Training - Behavioral Finance
- Stock Features of the Week - Some Longer Term Trades
Stockscores Market Minutes Video
The future direction of a market is affected by the outlook for alternate investments. Often, investors will buy a stock or sector because it is the best option even if doing so seems to make little sense otherwise.
http://youtu.be/AFB0KV6R-GY
Stockscores Trader Training - Lessons from Behavioral Finance
While we hear about how markets are traded by computers more and more, I believe that it is still people that move markets. The computers take little bit of profit along the way and may affect the short term liquidity for stocks, but trends and substantial price moves are driven by human judgment.
This makes it important to understand how humans make those judgments. Traditional stock analysis assumes that we make rational decisions based on the information we have about the company. However, what one person considers to be a rational decision might be considered completely foolish by another. Many investors will make moves that are predictably irrational.
Behavioral economics and finance are fields which have still not hit the mainstream, but many of the theories of these disciplines are part of my approach to the market. Here are some areas of research by behavioral theorists that I find are applicable to what we do as trader and how they relate to some of my trading concepts:
Up trends start slowly, there are often pull backs early in the trend.
"A conservatism bias means that investors are too slow (too conservative) in updating their beliefs in response to recent evidence. This means that they might initially underreact to news about a firm, so that prices will fully reflect new information only gradually. Such a bias would give rise to momentum in stock market returns." Bodie, Kane and Marcus (2005)
People tend to make judgements by what has happened recently rather than what happens most of the time.
"Gambler's fallacy stems from two sorts of confusion. First, people have very poor intuition about the behavior of random events. With gambler's fallacy, they expect reversals to occur more frequently than actually happens. The second source of confusion stems from the reliance on representativeness." Shefrin (2000)
For most people, profits in the stock market are short term loans.
"People are overconfident. Psychologists have determined that overconfidence causes people to overestimate their knowledge, underestimate risks, and exaggerate their ability to control events. Does overconfidence occur in investment decision making? Security selection is a difficult task. It is precisely this type of task at which people exhibit the greatest overconfidence."
Nofsinger (2001)
How we judge information is largely dependent on our mood.
"The discovery that the weather in New York City has a long history of significant correlation with major stock indexes supports the view that investor psychology influences asset prices."
Saunders (1993)
People often wait to buy a stock until it has been going up for a while, in the end, paying too much.
"People prefer the familiar to the unfamiliar"
You are not smarter than the stock market.
"The illusion of control is the tendency for human beings to believe they can control or at least influence outcomes which they clearly cannot."
For every trade, there is a buyer and a seller. The buyer thinks the stock is going up, the seller thinks the stock is going down. One of them is wrong.
"Psychologists Hillel Einhorn and Robin Hogarth (1978) have studied the general issue of why people persist in beliefs that are invalid, that is, why they succumb to the illusion of validity. Einhorn and Hogarth suggest that people do so because they are prone to search for confirming evidence, not disconfirming evidence."
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This week, I ran the Stockscores Simple Weekly Market Scan in search of stocks making breaks from predictive chart patterns on the weekly time frame. First, I set my default chart time frame to 3 year weekly (using the Charting tab found under the large chart). This allowed me to view these charts from the Market Scan results. That process revealed a couple of stocks that have good potential for the months ahead.Back To Top
1. CAAS
CAAS is breaking out to new highs after building an ascending triangle pattern over the past year. This is a good set up for the start of a long term upward trend. Support at $8.50.
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2. ENPH
ENPH has been stuck under $10 resistance for over a year but is now breaking through that important psychological barrier, indicating investors are optimistic about the company's future. Support at $8.50.
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References
Get the Stockscore on any of over 20,000 North American stocks.
Background on the theories used by Stockscores.
Strategies that can help you find new opportunities.
Scan the market using extensive filter criteria.
Build a portfolio of stocks and view a slide show of their charts.
See which sectors are leading the market, and their components.
Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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