Behavioral Finance And Technical Analysis
As humans, we have emotions and other factors that can have an impact on our decision making. For example, getting rid of an item you may have an emotional attachment to would be a difficult decision to make. This can influence your decision to keep the item instead of getting rid of it.
Let’s first start with the definition of traditional (conventional) finance. Traditional finance assumes investors behave rationally. This theory dismisses the idea of people’s emotions getting in the way of their decisions. They also believe that prices are correct and equal to intrinsic value. However, this theory is not in touch with the real world because investors have many influences that cause them to make irrational choices. Behavioral finance acknowledges that investors are human and can be driven by their emotions to make decisions.
What is behavioral finance? Behavioral finance believes “that conventional financial theory ignores how real people make decisions and that people make a difference. ” The belief is inventors make “inconsistent or suboptimal decisions. ” Investors are not only influenced by the sentimental value but also by information they receive from the news or social media. This information can be misleading and may lead investors to process it incorrectly. Behavioral finance has its own set of errors that can cause investors to make poor decisions. These biases are errors in information processing, behavioral bias and limits to arbitrage. Errors in information processing cause investors to misestimate the true probabilities. Four types of errors in information processing are forecasting errors, overconfidence, conservatism, and representativeness bias. Investors are also faced with behavioral biases. Behavioral biases that are barriers to investment success are framing, mental accounting and regret avoidance. Limits to arbitrage refer to circumstances where rational arbitrageurs benefit from behavioral biases. Factors such as fundamental risks, implementation costs and model risks restrict profiting from mispricing.
Technical analysis tools are used to search for a momentum and to help predict stock market trends. Tools used by investors are moving average, relative strength, confidence index, Elliot waves, support and resistance levels, and put/call ratio. One of the most common technical analysis indicators used by investors is the moving average. This indicator helps to measure the direction of the current stock market trend. The moving trend is calculated by averaging the mean of a given set of values. For example, to calculate a 20-day moving average you would add the closing price for your stock(s) from the past 20 days and then divide the outcome by 20. To recalculate the moving average the following day, you would drop the oldest price and add the newest price.
