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Sunday 19 April 2009

Technical Analysis, Killed By Popularity

Heisenberg’s Investment Principle

In quantum mechanics the Heisenberg Uncertainty Principle expresses the finding that in attempting to measure anything at the sub-atomic level you inevitably change what you’re measuring. You can determine a particle’s position or its speed but never both at the same time.

In stockmarket investment a similar thing happens whenever someone identifies a sure-fire way of making money. No sooner do they publish their findings then their technique fails. It’s all down to human psychology and it’s the same reason why popular technical analysis techniques can’t reproducibly produce above average market returns. Heisenberg rules, OK?

Technical Analysis

Technical analysis is much beloved of the investment industry. TA involves studying charts of past market data while avoiding fundamental analysis of the target companies. Archetypical patterns and various indicators are used to identify trends which are believed to be representive of the group psychology of investors and, therefore, predictive of future share price movements.

TA keeps lots of analysts in gainful employment – gainful for them and their employers, that is, heaven forfend it should be good for their clients. The technique has a great attribute in that it reliably produces buy and sell signals, creating fully justified commission generating trades. Sadly this says nothing of its ability to provide the kind of market outperformance needed to justify the management fees and commissions it attracts. In fact it’s fairly easy to show that it can’t produce anything better than average performance, on average, if lots of people are doing it.

Mechanical Methods

Meanwhile other ways of picking stocks based on mechanical or semi-mechanical strategies have their own problems. A whole slew of methods have been identified and back-tested to death showing that over long periods of time they have reliably generated above average returns for investors. Usually some bright spark comes along and writes them up in a best-selling book and then, with monotonous regularity, such methods promptly stop working as soon as they become popular.

The reason behind the failures of both technical analysis and well back-tested semi-mechanical strategies is the same. It’s the human mind playing tricks again.

Mongolian Markets

Picture the technical analyst who is spending their time analysing charts, looking for telltale signals for buying and selling. Consider also that there are thousands of such analysts, all studying the same charts, and that they’re backed up by the formidable processing power of the most powerful computers that the financial industry can bring to bear. All of this capability is being expended in a search for excess returns.

So, what’s the chance that any single individual is going to find something that the rest of this analysis hoard hasn’t? Let’s leave that to one side, however, and assume that somewhere there is someone who can reliably do this. Maybe they’re the only analyst in the world specialising in the Mongolian stockmarket, or something. So they start outperforming the wider market and attracting funds and followers. Soon they’re on a bit of a roll and with more money they’re making bigger trades and providing even better returns.

Others notice and suddenly a whole raft of Mongolian Market Funds spring up. Mongolia’s the place to invest in. However, the return on our ace analyst’s fund isn’t quite so good anymore now that everyone’s competing with the same information. Other analysts are looking at the same data and some of them are getting in a little bit earlier. It’s about this point that our analyst publishes a popular investing book entitled “The Yak Trader” which sells a storm, attracts a throng of private investors and allows her to retire and write articles in newspapers about how rubbish the new generation of Mongolian fund managers are.

Failure in the Court of Public Opinion

Of course it’s the very popularity which leads to the technique’s failure. If there is some reliable way of outperforming the stockmarket then as soon as others know about it they’ll start to try to get a little bit ahead of the curve. If there’s a definite technical signal that reliably indicates a buy then people will start to invest just slightly ahead of time and, of course, will disrupt the signal, which is dependent on detecting the trends caused by human group behaviour. This is pure Heisenberg.

The same applies to mechanical or semi-mechanical techniques. Even as venerable an investing tradition as value investing can suffer from similar problems. The whole point of value investing is that it’s about buying into unpopular stocks. So what happens when value investing becomes the most popular investing technique?

It stops working, that’s what. Just like all the other techniques.: Dogs of the Dow, O’Shaughnessy, Higgins, Coppock indicators, the Zulu Principle. You name ‘em, they’ve all wilted under the weight of success.

Does Value Investing Work?

The only thing about value investing is that it’s not easy either technically – because you need the skill and patience to sift through the data to find genuine value stocks – or psychologically – because it’s a method that will reliably fail from time to time for “good” reasons. These reasons are normally the sudden popularity of growth stocks in some kind of boom. When reason goes absent then value normally reappears. When reason reasserts itself value disappears.

Even the doyen of value investing, Ben Graham, at the end of his life expressed doubts about whether value investing worked anymore:
In general, no. I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook "Graham and Dodd" was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent I'm on the side of the "efficient market" school of thought now generally accepted by the professors.

If value investing succeeds over time it’s because it’s hard to implement. Many value plays can’t be found through short-cuts and require detailed research and painstaking analysis. Unsurprisingly many of us don’t succeed in our quest to be value investors.

Easy Technical Analysis

Technical analysis, on the other hand, is apparently easy – technically. It’s easy to buy software to do the analysis automatically which kind of ignores the obvious fact that if the software’s popular then there must be a lot of people doing exactly the same analysis. It avoids the hard slog of analysing the details behind the charts, looking at the genuine business of the companies targeted for investment. Not that I’m against shortcuts and the avoidance of hard work. Quite the opposite, in fact, I’m all in favour – I just doubt that it’ll ever actually yield results that are better than using a pin and a blindfold.

In fact if technical analysis does work – and I’m a sceptic not a cynic (so I’m willing to be convinced) I’m sure it’s being done quietly in a backroom somewhere by someone using their own methods and tools. Just like value investing if it’s to work it’ll require hard work and detailed analysis. The stockmarket doesn’t do free lunches.

Don't Tell Heisenberg

Anecdotally there are lots of people who’ll tell you that they get good results using some combination of technical and fundamental analysis. This may well be true although it would just be nice if they actually published their trades ahead of time so we could all see. Only if they did that and were even mildly successful then everyone would start copying them and soon they’d stop being successful.

So if there is anyone out there using either a technical analysis or a mechanical analysis technique that’s reliably producing above average returns then avoid telling anyone about it. Otherwise Heisenberg will get you.

Related Posts: Bulletin Boards Are Bad For Your Wealth, The Media, Fear and Stockmarket Manias, You Can't Trust the Experts with Your Investments

1 comment:

  1. Any comments on the self-fulfilling aspect of TA? If enough people believe there is a range for a particular stock then when it is hits the bottom of this range they will buy and the price will move up ...