For a certain kind of investor, technical analysis is awfully tempting. Instead of the plodding analytics of fundamental analysis, it involves fast-moving concepts like trends, momentum, and the possibility of being smarter than everyone else. Good stuff.
Unfortunately, it also tends to be really, really bad for investors. A new study quantifies the effect -- and it isn't pretty.
What is it?
People who use technical analysis buy and sell stocks based on what they think the market will do next. It involves taking a broad snapshot of what's happening in the market, including how much people are trading, which direction prices seem to be going, etc., and using different tools to try to make sense of all the data.
On the other hand, fundamental analysis is about diving deep into a company and getting an understanding of its business model, its strengths and weaknesses, and how you think its performance will change in the future.
The key difference lies in what you're trying to predict and how you go about it: with an individual company, you're trying to understand how well it operates and whether it's set up for the future. With technical analysis, you're trying to predict what the future will be. It's as complicated and analytical as it sounds, and involves a lot more trading, effort, and time.
So does it work?
In a forthcoming paper, researchers analyzing 5,500 individual investors and their accounts in the Netherlands finds that, on average, using technical analysis leads to a 0.6% decline in gross monthly portfolio returns. The higher level of trading it involves adds an additional 0.2% in losses every month (please note, this paper wasn't comparing technical and fundamental analysis specifically, but rather technical analysis versus "everything else").
In other words, investors who use technical analysis are paying with worse performance.
But it turns out that the costs aren't uniform across technical traders. The effect is particularly pronounced for what the authors call "high derivative rollers," who use technical analysis and trade derivatives. For these enthusiasts, the average cost of technical analysis is 1.4% per month, with an additional 0.3% fee for high turnover.
All in, that means the strategy is costing those investors 1.7% in lower returns every month. (Not using technical analysis in your derivatives trading? That will only cost you 0.56% a month in worse performance.)
Why is it so bad?
The authors attribute much of the problem to the fact that people who use this strategy are generally grossly under-diversified, which means they take on a lot more risk relative to the payoffs they could get. Individuals also pay pretty high transaction fees, which also lowers returns, especially if you start trading a lot. Finally, the reality is that few of us have the time, resources, and expertise to become true masters of the strategy.
Take this in comparison to fundamental analysis. If you think a company has a great business model, solid financial footing, and loyal customers with a lot of room for growth, you can buy it and hang onto it. You still don't know what's going to happen next, but you do have a grasp on whether that company has the flexibility and strength to adapt, grow, or maintain its advantage. The little in-between movements of the stock's price might catch your attention, but if you're in it for the long haul you'll be patient.
In other words, with fundamental analysis you're betting on company qualities rather than events, and you're not moving in and out of those bets based on the whims of the market. It's a long-term strategy that we Fools think is much more conducive to investing success.
So what do I do?
While it's very tempting to believe that we as individuals are above average and that the investing world is our oyster, the fact is that the vast majority of people only end up hurting themselves with technical strategies.
Yes, you can do it, but the evidence shows that you're very unlikely to succeed -- not because of anything bad about you, but because the odds are pretty well stacked against you. Between a lack of diversification, a lack of time and expertise, high fees, and the sheer unpredictability of the future, technical analysis sets up most people for failure.
The point is, what you learned back in investing kindergarten really is sound. Diversify. Don't trade so much. Stay humble and patient.
And please, step away from the technical charts.