I've never quite understood how to use technical analysis in investing. Technical investors claim to spot buying or selling points based on trading trends or patterns, but all the fancy charts with their "Bollinger Bands" and "evening stars" just leave me cross-eyed.
These complicated patterns hardly seem to tell a story about a stock, much less the underlying company. However, they might tell a story about the investors themselves. I have a theory regarding the appeal of technical analysis, which shares a lot in common with what I call the "boombox bias." Further, as a recent study reveals, it might also explain the shortcomings of the world of "chartists."
The paradox of the perfect boombox
The "boombox bias," as you might have imagined, is not a documented psychological effect. Instead, I made this term up to describe the tendency of teenagers to seek out overcomplicated solutions to ordinary problems. For some perspective, let's flash back to the 1990s for a minute.
Around my 15th birthday, my friends and I unofficially entered into a contest to find the biggest, flashiest boombox for our respective bedrooms. At the time, we lacked a driver's license and thereby any sort of social life, so we spent our Friday nights jamming out to Hootie and the Blowfish until the wee hours of the morning. Our parents were none too pleased about our lifestyle choices, to be sure, but that just made it all the more appealing to us.
The contest (the details of which we never actually discussed) unfolded in a predictable manner. We all saved our money to track down the most elaborate stereo system Circuit City offered in the hopes of one-upping each other's bass effect on the latest Green Day album. Imagine a stereo like the one pictured here, only with more spaceship-like features:
Our plastic-encased sound machines even operated like spaceships. The speakers would flex and thump as though they could take flight any minute. And there were enough knobs, sliders, and glowing buttons to rival the inside of a cockpit.
The sheer complexity of Sony or Panasonic's latest noise machine meant that it trumped everything that came before. Surely, we thought, this was the best audio technology those companies had ever encountered.
Flash forward two decades, and it's hard to find anyone using a stereo with more than even a few buttons or dials. I own a stand-alone speaker with exactly one switch -- for the volume. It works flawlessly.
Over the years, simplification has won out over complexity. At the same time, my friends and I have realized what we were missing back then: the point.
We were so distracted by the bells and whistles that we confused the signal with the noise, no pun intended. We forgot to stop and ask a simple question: "Why?"
If we had done that, of course, our little competition would not have existed. Practically any sound system available would have been sufficient, not to mention 10 times better than anything our parents grew up with.
Why we seek out complexity ... and why it fails us
I tell this story because my friends and I employed two biases that I believe exist in the world of technical investing. The crux of these can be summed up in two relevant takeaways from my anecdote:
1. We were biased toward complicated stereos, even though they failed to offer an improved listening experience.
2. We became so enamored with the machine that it distracted us from the music itself. We were too busy hunting for gaudy devices when we should've been hunting for better albums (yes, I know).
I believe the first tendency explains at least part of the reason technical analysis can be appealing, especially to novice investors. The complexity of it -- including everything from "indicators" to "oscillators" -- suggests there's merit to the practice in the eyes of investors. After all, everyone knows Wall Street is a fast-paced world driven by high-frequency trading, so to beat the market it seems you need to move -- and even trade -- at the pace of the market.
Of course, this also means you need to possess an intuition for stock movements that's been fine-tuned for decades. Building that skill can be a costly exercise. In addition, there are over 400 technical-analysis vocabulary terms on Investopedia that you might want to get familiar with, which leads me to my second point.
Here's how Investopedia describes the practice of chartists: "[T]echnical analysis attempts to understand the emotions in the market by studying the market itself, as opposed to its components."
Technical investors try to predict near-term stock price movements based on their understanding of the market's emotions -- not the underlying drivers of businesses. In theory, a savvy analyst could potentially master this approach. In reality, it's the emotions of the investor that ironically wreak havoc on their returns.
A recent study shows that biases plague technical investors to the point where they consistently underperform their buy-and-hold (see Foolish) peers.
The findings of the Dutch financial economist Arvid Hoffman and American behavioral-finance professor Hersh Shefrin were published in February in a research paper called "Technical Analysis and Individual Investors." After observing the habits of 5,500 investors over a six-year period, Hoffman and Shefrin concluded the following:
"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."
Not only did Hoffman and Shefrin find that technical "chartists" trailed the average individual investor; they also put a number behind their findings: 7%. During the evaluation period, the investment returns from technical investors lagged behind by 7% per year!
When you consider the power of compounding, an annual shortfall of that magnitude could push your target retirement date by decades. That's simply startling.
And what's just as revealing is that Hoffman and Shefrin found absolutely no flaws with the act of performing technical analysis, only the behavior associated with it. As Hoffman pointed out to Reuters in an interview, "It is not that there is anything wrong with technical analysis in itself, but we found that it leads to investor overconfidence and very busy trading, which pushes up costs."
What you can do about it
Taking these conclusions into account, its easy to understand why we might be drawn to technical investing, and just as easy to understand why we so frequently fail.
Like a teenager flocking to the most decked-out music player, we're convinced that a complex investing approach can predict the ebbs and flows of a fickle, emotions-driven market. Meanwhile, our own emotions overwhelm a rational thought process, and our mistakes are magnified as we overcomplicate things even more with risky options.
To me, technical investing is like picking the winner of the Tour de France by observing the grimaces on the riders' faces. This strategy could work for a stage or two, but you're left with no knowledge of their track record, their team dynamics, or even their strengths and weaknesses in relation to the course. And wouldn't these things matter more in the long run (or ride)?
The same, in fact, holds true for investing, where the momentum of the business matters more than that of the stock. Next time you find yourself perplexed by a complicated investment strategy, do two things:
First, properly define the reasons why it makes sense.
Second, ensure that your analysis reflects the drivers of the business and not something altogether superficial, like the fluctuations of its stock price.
Hopefully this will steer you in a better direction than a snazzy chart.