Ferri: Technical Analysis Hurts Returns

June 05, 2014

Even Buffett conceded that technical analysis doesn't work.

Trying to predict price trends by studying charts is a popular investment technique. In fact, technical analysis is probably the most common form of securities selection because anyone can do it without much training. Predicting that prices will rise because they have been rising is an easy decision. Avoiding securities that have trended down is another easy decision.

For many investors, technical analysis goes well beyond projecting future prices from the latest trend. Ardent followers attempt to identify trading opportunities by using moving averages, relative strength, patterns such as head and shoulders or top/bottom reversals, lines of support, resistance, channels, flags, pennants, cup and handle patterns, and the list goes on.

The study of price trends is popular among individual investors and professionals, but does it lead to the right buy and sell decisions? That’s a tough question to answer.

Surprisingly little research has been conducted on the actual results from technical analysis. The existing literature essentially ignores the real-world performance and instead focuses on the theoretical effectiveness over select time periods when abnormal profits have been earned.

Until recently, the only study attempting to measure the trading records of investors who used technical analysis dates back to 1980. In “Portfolio Design and Portfolio Performance: The Individual Investor,” researchers Wilbur G. Lewellen, Ronald C. Lease and Gary G. Schlarbaum matched transaction records to investor survey responses from the period 1964-1970. Their findings suggested that technical analysis severely degraded the performance of individual investors’ portfolios.

Researchers Brad Barber and Terrance Odean published several papers beginning in the late 1990s that document the actual performance of thousands of individual investors who traded their own accounts. They found that those who traded more underperformed than those who traded less.

Undoubtedly, some of those investors studied by Barber and Odean relied on technical analysis, and it could be inferred that the investors who traded more than others may have used it. However, the focus of their studies were on overall results rather than how investors made decisions; thus, there is no hard evidence that technical analysis hurt or helped the investors.

 

 

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