Re: Technical Analysis and Individual Investors

I'm going to keep this short and sweet. I don't think it's worth dedicating more than a couple of minutes to commenting this study. I'm referring to last month's release of a paper written by Arvid Hoffman and Hersh Shefrin titled, "Technical Analysis and Individual Investors" (see here). Sam Ro over at Business Insider put together a nice piece on it today as well.

I got a bunch of emails and tweets towards me thinking that perhaps I would take offense to this study (Considering I'm a technician, and a proud one). But this paper doesn't really talk about the merits of technical analysis. it's more about the psychology behind individual investors. The study goes on to say,

"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"

Yea of course. But we already knew a lot of these things. Individual investors lose money on average, especially those that trade options. This is the case regardless of how they come to their conclusions (technical or fundamental).

Another problem is that this particular study that focuses on amateurs goes into how investors who report using technical analysis focus on speculating on short-term market movements. This is another easy way to lose money: amateur - check, speculating on short-term market movements - check. This is a money losing strategy, regardless of discipline.

Also, during the 7 years studying this small sample of Dutch discount brokerage clients, they focused on the short-term, rather than longer-term time frames and/or multiple time frames. One of the best parts about technical analysis is the ability to apply our tools across various time frames. The market is fractal. Our ability to start with longer-term trends and work our way down to short-term charts for entry and exit points is a huge advantage. Focusing on just the short-term makes you blind to bigger trends.

More Most importantly, we use technical analysis and price behavior to manage risk. This is what it's all about. Where are you wrong? Technical analysis is the best way to properly manage risk. Without looking a price, how would you be able to do that? Clearly, these Dutch retail investors are focused on hitting home runs through options, rather than just managing risk while participating in the strongest longer-term trends. That's a problem.

So I would not take this paper as "shots fired" towards technical analysis. I actually take it as more confirmation of things we already knew:

- Amateur individual investors trading options is a bad idea. Not a surprise.

- People who write "papers" prefer to write negative things about technical analysis, than fundamental analysis. Not a surprise.

- Individuals who hold more concentrated portfolios which they turn over at a higher rate earn lower returns. Not a surprise.

- The media loves the battle between technicians and fundamental analysis. Not a surprise.

Technical Analysis is an art. It's subjective. There are some technicians that are better than others. You can't just get into this market and start using "technical analysis" and assume you're going to make money. But with that said, Fundamental Analysis is also an art. It is just as subjective, if not more so. There are some fundamental analysts that are better than others. You also can't assume you can just get into this market and start using "fundamental analysis" and you're going to make money.

There are the Michael Jordans and Derek Jeters of the world: the best at what they do. But those are the exceptions, not the rule. For the most part, obviously, athletes are not Michael Jordan or Derek Jeter. Most athletes are people who we'll never hear about who are terrible basketball and baseball players. And it's not because they are right handed or left handed, shoot from behind the arc or prefer to focus on the post game. It's just that Michael and Derek did this for many many years, put in a lot of work, and only then did they see their sacrifices pay off.

Same thing with the market. Amateurs are not professionals (by definition). You have to put in the work and that takes time. So much time that eventually you're doing it for a living. Of those professionals, most of them are still bad at it. Most of them are not Jordan or Jeter. There are only a few of those.

So it's not so much the analysis, it's the application. And if you're one of those people who think that studying price doesn't help, then there's nothing I can do about that. A fundamental analyst once told me, "We do our best to ignore price as much as possible". I almost spit the food out of my mouth (their portfolio was down 45% that year). But for me, I'm a simple dude. There is only one thing in this entire world that pays us, and that is price - where you buy it and where you sell it. Knowing everything about a CEO, or a balance sheet, or GDP growth does not pay you a penny. Selling at a higher price than where you buy it is the only way to ever make any money. So we choose to focus on that.

The paper overall I believe is focused more on the psychology of individual investors at this dutch discount brokerage. It's not so much about which form of analysis is better than the other. It's about the psychology behind these investors who claim to focus on technicals and how they misuse it as most amateurs do. This should not be a surprise to anyone. I think the points that the paper makes are valid points and confirm a lot of the things we already knew. Not a big deal.