Is technical analysis mere hocus pocus?

As an investor, you’ll have seen some market commentators extol the virtues of ‘technical’ analysis, or charting.  And it’s easy to believe there is some science behind the approach.  But is there really?  And is it as successful as fundamental analysis, which looks at the earnings and cash flow of a business?

You should know that some decades ago I entertained the idea that there was merit in the approach but as access to computing power and funds grew, a colleague and I were able to test the veracity of all the common charting devices promoted by advocates of technical analysis.  What we discovered, and with the benefit of time, was that none of them worked better than random and only a few, in combination, produced results with a positive mathematical expectancy but even they failed to endure over time or when scaled.

Technical analysis and charting has broad appeal because we want to believe that there is an effortless way to make money.  And many promoters, if they don’t truly believe in what they are doing, are content to sell the promise of easy money.  Of course, the path of least resistance has enormous appeal – what could be better than looking at a computer screen and buying ‘when the red line crosses the blue line’ and selling when they reverse?

In reality there are two paths on which to approach the stock market.  The first is as a venue to purchase pieces of businesses whose long term value is determined by the path and magnitude of their earnings.  As investing legend Peter Lynch once said: stocks always follow earnings and cash flow – focus on them, and you will get the stocks right.

The alternative approach is to treat stocks like chips that rise and fall on a computer screen.  But betting on the ‘ups’ and ‘downs’ is an approach that treats the stock market as nothing more than a casino.  Charting is only concerned with the ups and the downs and many advocates of technical analysis suggest that even knowing what the underlying company does is irrelevant.

Warren Buffett once advised: “When promised quick profits, respond with a quick 'no.'"

Indeed, in reference to charting Warren Buffett has made several comments:

"Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard."

And

"Before reading (The Intelligent Investor) ...I tried my hand at charting and using market indicia to predict stock moments ...I listened to commentators. All of this was fun, but I couldn't shake the feeling that I wasn't getting anywhere."

And most tellingly, Buffett reportedly joked about charting with an audience at Vanderbilt University in 2005:

"I realized that technical analysis didn't work when I turned the chart upside down and didn't get a different answer.”

In 2014, two researchers from the Netherlands, Arvid Hoffmann of Maastricht University and Hersh Shefrin of Santa Clara University published a paper that specifically measured the results of trading by investors who relied on technical analysis. In their paper entitled Behavioral Portfolio Analysis of Individual Investors*, they analysed the trading results of Dutch investors over six years between 2000 and 2006 to “gain a better understanding of the relations among individual investors’ decision-making, the processes leading to these decisions, and investment performance.”

In 2006, the source of their data, a brokerage firm, surveyed all of its clients asking which techniques they employed to make investment decisions.  About 32% of these investors stated they used technical analysis exclusively or in conjunction with fundamental analysis and the researchers used a sample of 5,500 clients to conclude:

“In line with our expectations, we find that investors driven by objectives related to speculation have higher aspirations and turnover, take more risk, judge themselves to be more advanced, and underperform relative to investors driven by the need to build a financial buffer or save for retirement. Somewhat to our surprise, we find that investors who rely on fundamental analysis [despite tending to be overconfident because of the direct relationship between confidence and information] …outperform investors who rely on technical analysis.

Hoffmann and Shefrin found the investors using technical analysis had lower performance, on average, of about 8.4% per year.

Many investors approach me and tell me that they have found a charting technique that “works”.  It is possible to find methods that work for a while or even a few that have a sustainable ‘edge’ but to really test the method one needs to measure against a benchmark.  So before backing your previously undiscovered winning charting technique, go back and check whether it works better than simply buying and holding?  I have yet to hear of one that does.

Many articles debating the relative merits of fundamental and technical analysis conclude with a statement such as “the debate continues”, But for us, there is no debate.