#55 De Bondt, W.F.M (1993). Betting on trends: Intuitive forecasts of financial risk and. return. A Critical Appraisal.

Transcription

1 #55 De Bondt, W.F.M (1993). Betting on trends: Intuitive forecasts of financial risk and return. A Critical Appraisal Emily Giblin University of Newcastle Article sourced from a bibliography of behavioural finance by Mike Cox

2 Introduction This exploration seeks to critically analyze the article Betting on trends: Intuitive forecasts of financial risk and return by De Bondt W.F.M (1993) 1, with a view to determining both the strengths and weaknesses of the research. Particular reference will be paid to the study design applied, & the statistical methodology pertained, in addition to suppositions regarding the suitability of each of these study features. Furthermore, the analysis will delve deeper into assessing the practical applicability of the study findings in a real world financial setting, while recommending prospective research into the topic, based on the limitations discovered. Article Summary The study first sought to assess the observable trends in stock share prices, followed by the aspiration to empirically test whether such trends in stock share prices are a predictable value - a notion coagulated by previous research.the study exercised a sample of twenty-seven students, all of whom were MBA scholars, within a class setting. With an average age of 22 years, 25 males and 2 females, all of whom had previously taken at least two courses in finance, and thus made completely aware of the efficient market hypothesis 1, completed the study. The study reconnoitered a hypothesis that; changes in prices are somewhat predictable, with major stock market indices being mean-reverting over a 3-5 year horizon, where after a long bull market; an index decline is more likely than an upward movement 1. The study also hypothesized that after a period of fall in prices, the chances of a turnaround are higher than the chances of a further decline. The methodology involved playing a technical analysis game, where an overhead projector was used to present 6 graphs; each graph encompassed the prices of 48 undisclosed stocks 1. The graphs exhibited a plot of the S&P index on the vertical side of three bull

3 markets for the different years (1967, 1980 and 1986), and three bear markets for the different years (1970, 1974 and 1982), against the prices of such stocks in months, where the subjects were required to predict, (to the best of their ability), the prices of month 7, and the prices 13 months later. Additionally, subjects were required to give interval estimates of: 1) when they would expect the prices of the stock share to have a one-in-ten chance of the actual prices of the stock turning higher, and 2) an estimate at which there would be a one-in-ten chance that the actual prices of the stock would turn lower. The prediction errors for each forecast were then squared, and the individual with the least sum of squared errors was named the prize winner. The results indicated that on average, participants showed more optimism in bull markets than in bear markets, where the participants who saw an upward trend in the bull markets were classified as followers, while those who saw an opposite trend were classified as contrarians 1. In the bull markets category of the graphs, 50.6% of the participants were followers, while only 11.1% were contrarians, giving a difference that is statistically significant, where p< while almost equal percentages were found in either category for the bear markets. Additionally, the results indicated that 14.8% perceived a weak down trend in the bull markets, while 38.3% perceived a weak downtrend in the bear markets, giving values that are statistically significant in all cases 1. The researchers concluded that expected price changes do follow past trends, while the confidence intervals are skewed in the opposite direction from the immersed trend 1. An additional five variations of the fundamental main study, namely studies 2, 3, 4, 5, and 6 were conducted to address any conceivable limitations. Critical Appraisal Conspicuously, it is important to note that both bull & bear markets can be affected by judgment biases, in particular, the portent confirmation bias & post purchase rationalization. Each of these cognitive biases appropriates a rational decision by creating a flaw in

4 judgments that arises from errors of memory, social attribution, & miscalculations (a false sense of probability) - i.e. investors appear to be overconfident & over optimistic in bull markets, thus there is a likelihood that bull markets can momentarily be overbought or oversold 2. However, an oversold bull market is not a cause for concern, since it opens more opportunity for the bull stock to be overbought- thus the situation is corrected internally 3. Conversely, the diminutive investor confidence attributed to bear markets allows for further downward trend, thus creating an ever depleting financial setup 3. Furthermore, the study employed a sample of only 27 students within a class setting, whose sole motivation for participating in the study was the reward promised to the overall winner. Despite the fact that offering a reward as the motivator would encourage the participants to be keen in their assessment of the stock price trends, it is ultimately detrimental to factual outcomes 4. The reward motivation served to attract more superficial predictions from the participants at the expense of full financial expertise engagement. Thus, a manifestation which occurs when an individual is not motivated by a reward, but rather through a suitable research methodology that makes the subject fully participative, is required 5. Moreover, the application of a class setting technical analysis game, encourages participants to offer responses that are socially acceptable/generic, as opposed to full analytical engagement, since they would not want to appear to be deviating from the peer range with greater margins 6. Further, the sample manipulated consisted of only 27 participants, 25 males and only 2 female, as such,the mutual law of small numbers &gender parity were clearly unachieved. This gave results that are clearly skewed towards the male analysis of the stock share price trends, while negating the female version of the assessment 7. Additionally, the application of the study in a single class setting, with participants

5 who had almost similar characteristics in terms of education, age and gender negated the multiple and divergent analysis of the trends, which would be better assessed through incorporating diversity in terms of educational background, experiences, gender egalitarianism and different ages 8. Nevertheless, studies 2, 3, 4, 5 and 6 incorporated the essentials of an assorted study such as age, expertise, gender parity and different educational backgrounds, through applying random mail surveys. The findings of such studies are therefore more credible and practical, with less socially desired responses 9. In fact, the findings of studies 2 and 3 can be highly generalized 2. However, these studies are disparaged slightly - they negate interval estimates, which are essential indicators of the direction of the skewing of the confidence intervals 10. Real World Implications & Future Research The findings of this study have significant implications in terms of the real financial world, since the findings indicate the investment trends in the current financial market- that is, investors in the long-term tend to have regressive expectations, while investors in the short term tend to have static expectations 11. This serves to define what motivates different forms of investment in the financial markets 12, and thus could be manipulated in order to entice targeted financiers/depositors. In addition, the significance of the study findings to the real financial world is that, analyzing trends is fundamental towards determining the form of investment 3. The relevance attached to business students as the overall representative of real world investors, definitely limits the study 13. As such, supplementary research that will apply a true representation of diversity in the real world of investors is required. Conclusion Despite the fact that there are various subtleties that influence the changes in the prices of the stock shares in the market, expectations play a greater role in shaping the future of investment in the stock markets 14. Thus, while most investors are very optimistic in the

6 bullish market and perceive low chances of the bull stocks turning around to a downward trend, there is more pessimism and downward trend expectation for the bearish market 15. References 1) De Bondt, W.F.M. Betting on trends: Intuitive forecasts of financial risk and return. International Journal of Forecasting 1993; 9: ) Drazen, A. Self-fulfilling Optimism in a Trade-Friction Model of the Business Cycle. The American Economic Review.1998; 78(2): ) Stock Market Trends During Recession, Retrieved December 14, 2010, from 4) Baron, R.A. Psychological Perspectives on Entrepreneurship: Cognitive and Social Factors in Entrepreneurs Success. Current Directions in Psychological Science.2000; 9(1): ) Andersen J.V. Detecting anchoring in financial markets. Journal of Behavioral Finance 2010; 11(2): ) Cox M. Distortions in deriving preferences: loss aversion. The Psychology of Financial Decision Making. 2012; 3: ) Cooper, A.C., Woo, C.Y. & Dunkelberg, W.C. Entrepreneurs Perceived Chances for Success. Journal of Business Venturing. 1988; 3: Press; ) Festinger, L. A theory of cognitive dissonance. California: Stanford University 9) Young J.M. & Solomon, M.J. How to critically appraise an article. Nature Clinical Practice Gastroenterology & Hepatology. 2009; 9:82-91.

7 ) Forbes DP. Are some entrepreneurs more overconfident than others? Journal of Business Venture. 2005; 20(5): ) Weinstein, N.D. Unrealistic Optimism About Future Life Events. Journal of Personality and Social Psychology. 1980; 39(5): p ) Howitt D & Cramer D. Introduction to statistics in psychology. 4 ed. Harlow: Pearson Education; ) Nickerson R.S. Confirmation bias: a ubiquitous phenomenon in many guises. Review of general psychology.1998; 2(2): ) Oskamp, S. Overconfidence in Case-Study Judgements. Journal of Consulting Psychology.1965; 29(3): ) Russo J. E. & Schoemaker P. Managing overconfidence. Sloan Management Review. 1992; 33(2):7-17.