Behavioral Finance and Human Interaction Term Paper

Pages: 81 (22258 words)  ·  Bibliography Sources: ≈ 50  ·  File: .docx  ·  Level: College Senior  ·  Topic: Economics

Retail sales can serve as a measure of the economy's strength. Low retails sales often mean that the economy is weak, which could cause a drop in the Federal Reserve interest rates.

The Consumer Price Index (CPI) measures the average change in the prices that consumers pay for a fixed amount of goods and services. The Federal Reserve monitors this data and uses it as a key measure if inflationary pressure on the economy. As a general rule, if the CPI's value increases, the money supply will tighten.

The Gross Domestic Product (GDP) measures economic activity. It is the output of all goods and services created by labor and property in the United States. GDP provides important information on the current economic climate.

Characteristics of Winning Stocks

According to many research studies, there are several characteristics of winning stocks. According to William O'Neil (1988), a professional investor: "The first step in learning to pick stock market winners is for you to examine leading winners of the past to learn all the characteristics of the most successful stocks." recent study shows that, over the past four decades, the top performing stocks have shown seven basic characteristics (Gross, 1997). First, a company consistently has increases in recent quarterly earnings per share of at least 25%. Its three, four or five-year annual earnings per share growth rate are greater than 25%.

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Many successful investments are made when a stock hits a new high and is emerging from a period of price consolidation. New companies with new products or services and improving sales are often successful.

Companies with a total number of shares outstanding between five and 30 million are often good bets, as are the top performing leading stocks in leading industry groups. In addition, stocks that are owned by at least one quality institution have shown promise. When a stock performs well in the general market daily, it is usually headed in a good direction.

Current Earnings

Term Paper on Behavioral Finance and Human Interaction Assignment

According to William O'Neil (1988): "The stocks you select for purchase should show a major percentage increase in the current quarterly earnings per share when compared to the prior year's same quarter."

Many of the most successful stocks have shown a significant percentage increase in the current quarterly earnings per share when compared to the same quarter the year before. In a forty-year study, three out of four stocks showed earnings increases averaging more than 70% in the quarter prior to a major price advance (Wurman et al., 1990). The one that did not show a substantial current quarter increase did so in the following quarter.

Annual Earnings

According to William O'Neil (19880, "Each year's annual earnings per share for the last three, four or five years should show an increase over the prior year's earnings."

While evaluating a company's quarterly earnings is important, it may be even more important to evaluate a company's annual compounded earnings growth rate. A recent study shows that the majority of top performers had a three, four or five-year average annual compounded earnings growth rate of 24% just before their greatest price moves.

When buying stocks, investors are encouraged to look for companies demonstrating consistent long-term growth, or a three to five-year annual growth rate greater than 25%.

Something New

According to William O'Neil (1988): "It takes something 'new' to produce a startling advance in the price of a stock."

Almost the entire group of top performing stocks studied in the 40-year period experienced something 'new' just before their major price advances. For example, a new product or service many have significantly increased sales and earnings. This is due to the resulting increased consumer demand.

In addition, nearly all of these stocks were at or near a new price high right before their greatest price movement. However, studies reveal that less than 2% of investors will purchase a stock when it is at a new high.

The Law of Supply and Demand

According to William O'Neil (1988): "The law of supply and demand is more important than all the analyst opinions on Wall Street."

The law of supply and demand applies to all goods and services, including stocks. If a stock's supply is small and there is a lot of demand for that stock, the stock's price will increase.

If a company has a lot of numbers of shares outstanding, it would take a large buying demand to increase the stock price. Conversely, companies with a small or moderate number of shares outstanding require only a moderate amount of buying demand to markedly influence their stock's price.

Short Selling

When examining the stock market, it is important to understand the concept of short selling, which is basically a sort of reverse stock buying. Most people buy a stock hoping that it will go up in price.

However, with short selling, investors sell the stock before buying it in the hopes that it will go down in price. According to William O'Neil (1988): "Short selling is a topic few investors understand, and in which even fewer succeed."

In short selling, an investor borrows shares from a broker, sells them in the open market and gets the profits from the sale. The investor hopes that the stock will go down in price so that he can buy the stock back at a lower price. He then replaces the shares borrowed from the broker and makes a profit. Investors tend to sell short if they believe that the market is headed for a dramatic decline or that a stock is about to drop.

A great deal of financial theory is based on the assumption that humans will act rationally and take into account all available financial data when making decisions. However, research shows that human behavior is often irrational and unpredictable. Several incidences of irrational behavior and human errors have been reported in research studies in recent years.

For example, in "Against the Gods," Peter Bernstein reported that evidence "reveals repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty. (p. 224)"

Market Direction

According to William O'Neil (1988): "Be objective and recognize what the marketplace is telling you.... The fastest way to take a bath in the stock market or go broke is to try to prove that you are right and the market is wrong."

The current condition and direction of the overall market heavily influences a stock's performance. Therefore, investors need dependable tools to determine exactly what type of market they are in. The market could be bullish, with rising prices, or bearish, with decreasing prices.

Stock Market Changes

Over the past few years, the stock market has become one that is price volatile and driven by liquidity. Today's stock market seems to have little regard for fundamental values. Instead, it seems to react more to the emotional mood of its investors, swinging in different directions at a fast pace. As a result, researchers today have developed certain indicators that aim to weigh emotion in the market to determine when it could shift.

Put/Call ratio is the amount of put options traded divided by the number of call options traded (Gross, 1997). When large amounts of call options are traded, it shows that investors are confident in the market. However, when large numbers of put options are traded, it shows a lack of investor confidence.

The Option Volatility Index (VIX) relates to the premium paid for options on the OEX. It is expressed as a percentage of prices. The VIX usually goes down as the market goes up and goes up as the market goes down. Researchers say that deviations from the expected behavior are the result of human emotions.

Another tool that is used to weigh emotion in the market is the tick number, which refers to the number of stocks trading on the NYSE trading on an up tick, which means they are trading above the preceding price, minus the number of stocks trading on a down tick, which refers to stocks trading below the preceding price. High positive ticks usually occur at intra-day highs while high negative ticks tend to occur at intra-day lows.

According to the FirstCapital Corporation Web site (2002): "We relate the extreme tick values to an index price such as the S & P. 500 price. Repeated extreme tick numbers around the same price on the index within one or two days, indicate a resistance level above the market or a support level below the market.

When the market trades thru the possible support or resistance level on a much reduced tick number it means that there is no support or resistance level and the market will continue to move in the same direction."

There are several other measures of market extremes, including the percentage of stocks above various moving averages and the number of stocks above various averages by one or two standard deviations.

Investor Emotion

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APA Style

Behavioral Finance and Human Interaction.  (2003, February 12).  Retrieved April 4, 2020, from

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"Behavioral Finance and Human Interaction."  12 February 2003.  Web.  4 April 2020. <>.

Chicago Style

"Behavioral Finance and Human Interaction."  February 12, 2003.  Accessed April 4, 2020.