In Defense of Technical Analysis

One of the ways to beat down a strategy is to apply it wrongly and claim since the results does not match expectations, the strategy has to be wrong. Technical Analysis has its faults and there is no denying that. But claiming that those who use technical analysis as the tool of choice tend to have their performances drag down is doing it a bit too far.

That thought is based on a survey which has been done by Arvid Hoffmann of Maastricht University and Hersh Shefrin of Santa Clara University (Link). The key reasons they come up for the under-performance are:

1. Investors using technical analysis are disproportionately prone to have speculation on short-term stock-market developments as their primary investment objective. 

2. Investors tend to hold more concentrated portfolios which they turn over at a higher rate

3. Investors are less inclined to bet on reversals, choose risk exposures featuring a higher ratio of non-systematic risk to total risk

4. Investors engage in more options trading, and earn lower returns.

The biggest problem area for me in terms of Technical Analysis is the confusion whether it’s a science or an art. While it’s nice to say that it’s both a science and an art, it’s plainly illogical that something can be both. Think about Modern Art being said to be an Art (which is true) as also a Science. I am not sure if there is any other field where both Art and Science are seen to be acting in tango.

Now, let’s go back to the four points which the researchers say are the key reasons for the underperformance of investors who use Technical Analysis for their decision making.

1. The time frame of a trader / investor using technical analysis is way too short compared to an investor who uses fundamental analysis as his tool. While a fundamental investor gets 4 data points in any given year (4 Quarterly Results), guy who uses Technical analysis has a lot more data points based on what kind of time frame he operates in. A investors who looks at Daily chart would have around 240 data points to consider in any given year while a Investor who looks at a weekly chart will have 52 data points to consider in a year. No matter what time frame one chooses, the data points generally exceed the data points available to a fundamental investor

Having more data points is both a advantage and a disadvantage. Let’s take a example where more data points would have worked in the favour of the Technical Analyst – Satyam Computers. Long before the shit hit the fan, most guys using Technical Analysis as their tool would have seen that it made no sense to trade the stock with bullish bias. For a Value /Fundamental Investor on the other hand, Satyam was a strong case of a stock available for cheap.

2. It is interesting that the survey finds that Investors hold concentrated portfolio’s / bets compared to investors using other methods who may be holding diversified portfolios. A lot of water has flown down the bridge as to whether it’s better to hold concentrated bets or diversify as much as possible. Both have their advantages and disadvantages and I doubt that it can be proven that either concentrated or diversified portfolio is the best bet.

Personally I believe in concentrated bets since the more number of stocks one is exposed to, the closer we get to ordinary performance. The same was proved when I did the test of random portfolio strategy as well. But I strongly doubt that a concentrated portfolio is the key to under-performance since I know of many value / fundamental investors too who use the same approach and have been able to beat market averages by a mile.

3. This point interestingly goes against the point number 1. If investors using technical analysis as their trading tool are trading more, it goes on to prove that they are betting on reversal s to the existing trend at multiple points and in turn can miss the big rally when it comes.

4. Option trading as such has nothing to do with Technical Analysis but since Option traders are short term traders and are betting on charts to decide on what stock and what strike to buy, it’s easy to get clubbed with Technical Analysis even though one can search the entire technical analysis vocabulary and find not a single instance of a tool devoted to options.

In an earlier blog post, I had written about how people buying cheap options is not the path to riches and instead will result in ruin of capital in the long run. But then again, options are pretty enticing since unlike stocks, they can double / triple in no time at all. 

But Technical Analysis as such has no role in how investors / traders risk their capital in the markets. Option trading is similar to buying lottery tickets (though the odds here are much better) and hence not something that is bound by any strategy other than human greed.

To me the biggest negative is the fact that Technical Analysis as a tool is far from refined and adapted to the world where it’s important that it’s scientifically proved beyond doubts. If I were to buy stocks based on PE, that would not make me a Value / Fundamental Investor but if I were to draw a line on a chart, I am seen as a Technical Analyst. End of the day, it’s the perceptions that seem to matter more than reality.

Over period of time, I myself have debunked multiple strategies that are associated with Technical Analysis and showed how they fail the traders / investors who use those tools. But to claim Technical Analysis as a whole is quack is akin to throwing the baby with the bathwater.