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New Paper Says That Chart-Obsessed Technical Analysis Traders Are Fantastic At Losing

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New Paper Says That Chart-Obsessed Technical Analysis Traders Are Fantastic At Losing

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There are two schools of financial market analysis: 1) fundamental analysis, which is concerned economics, financial statements, earnings, and anything else that you would assume would justify a value in a real-world sense and 2) technical analysis, which attempts to forecast prices by studying past price movements.

Fundamental and technical analysis aren't totally mutually exclusive. But the folks who focus on the latter are more easy to identify as they dedicate a larger amount of their time pining over charts.

Fundamental analysts tend to spend more time bashing technical analysts than vice versa. So, they were probably happy to hear about a new study challenging the merits of technical analysis.

FT Alphaville's Dan McCrum alerted us to the paper modestly titled "Technical Analysis and Individual Investors" by Arvid Hoffman and Hersh Shefrin, who use transaction records from a Dutch discount broker from 2000-2006.

By considering actual trades, the authors are able to consider the very real impact of behavior biases. Indeed, the authors conclusions appear to be more about psychology than technical analysis itself.

"We find that individual investors who use technical analysis and trade options frequently make poor portfolio decisions, resulting in dramatically lower returns than other investors," they write.

"Overall, our results indicate that individual investors who report using technical analysis are disproportionately prone to have speculation on short-term stock-market developments as their primary investment objective, hold more concentrated portfolios which they turn over at a higher rate, are less inclined to bet on reversals, choose risk exposures featuring a higher ratio of nonsystematic risk to total risk, engage in more options trading, and earn lower returns."

The authors quantify the underperformance:

The magnitudes are economically important: controlling for concentration and turnover, the marginal cost associated with technical analysis is approximately 50 basis points of raw return per month. Turnover associated with technical analysis adds a further 20 basis points per month of cost. Concentration adds an additional 2 basis points.

And it's worse for people who love to trade:

A major finding from our study concerns investors who both trade options frequently and use technical analysis. For “high derivative rollers,” the marginal cost of technical analysis from poor portfolio selection is 140 basis points, not the 50 basis points which we find for the full sample of investors, with turnover linked to technical analysis adding an additional 29 basis points of cost. Importantly, we find that outside the group of high derivative rollers, the average cost of using technical analysis is small and not statistically significant.

The paper does not appear to be rebuking technical analysis itself. Rather it seems to be more about the psychology of those who employ it. Here are the authors:

Our paper makes three contributions to the behavioral finance literature on individual investors. First, we find that the choices of investors in our data using technical analysis are consistent with the behavior of subjects in experimental studies who use price charts. Second, we find that the behavioral traits of investors using technical analysis are similar to those which the literature links to excessive optimism and overconfidence. Third, we find that high derivative rollers who use technical analysis and have speculation as their primary investment objective exhibit the same behavioral traits as investors who favor lottery stocks.

"The general advice from behavioral finance for individual investors is that they restrict their attempts to beat the market, and instead invest most of their portfolios as if markets were efficient," the author write in their conclusion. "Doing so helps them avoid shooting themselves in the foot as a result of falling prey to their own psychological vulnerabilities. Our findings suggest that this advice is apt for individual investors using technical analysis, especially if they are trading options online through a discount broker."

Read more: Technical Analysis And Behavioral Biases - Business Insider

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March 20, 2014

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