Let’s just call it how it is: Two of the basest human emotions are greed and fear, and they’re responsible for moving the stock market every single day.
When it comes to investing philosophies, there are two main camps: Fundamental (or quantitative) and technical analysis. The first relies on inputs like breaking down a business’s financials and SWOT analysis to determine whether a stock is a good investment. You know, things that an actual business owner might be interested in. It’s in this camp that you’ll find most long-term investors.
Technical analysis, on the other hand, involves looking at squiggles on a stock chart and trying to predict future squiggles through those patterns. Both strategies appeal to our greed, but “technicians” want returns now. They thrive on instant gratification, on immediate returns.
Well, nothing wrong with immediate returns, right? Everyone wants to get rich quick! The only question now is: Does technical analysis work? Can you make money with technical analysis?
The answer …
In Short, No.
First of all, “chartists,” or those who trade based on the movements of charts and not the integrity of the underlying business, tend to trade in and out of stocks far more frequently than fundamental investors. That’s because … well, they want to make a quick profit. And charts are more apt to change quickly than a company’s general financial condition.
But guess what trading more frequently does? It racks up trading fees. It doesn’t end up being the fees themselves that hurt you, but the compounded returns you missed out on that hurt the worst.
Check out the returns you’d be missing out on if you invested $100,000 over 30 years, expecting a conservative return of 6% annually, and spent roughly 0.9% of that each year on trading fees.
Just the difference between 0.25% — a typical fee for a low-cost index fund — and 0.9% a year is staggering over the long term. Nearly $100,000 in profits you missed out on.
And for many individual investors, 0.9% in fees every year might be a conservative estimate.
Let’s say a trade costs you $5.95. If you take a $1,000 position, you’ve got to trade in and out of it to realize a gain, so that’s $5.95 x 2 = $11.90, or 1.19%. In other words, your position has to gain 1.19% just for you to break even. That’s how trading fees erode your returns over time.
At 1.19%, over 25 years (again, at a conservative 6% compound rate of return), you’ll give up 33.4% of your potential return to fees. Over 50 years, that number jumps to 47.2%.
In fact, you’d have to trade in average blocks of $4,760 to achieve the 0.25% expense ratio on our theoretical index fund. That prices a lot of Main Street investors out of being able to intelligently trade on the virtues of technical analysis.
And that’s before we consider that, no matter what kind of approach you take, you’re likely to badly miss the tops and bottoms of the market, making the gains you missed out on even more dramatic. (Don’t believe me? Try this simulator, where you can try to day-trade real stocks against their real charts.)
While overtrading, mistiming the market and basing decisions off gyrations on a chart may be the most obvious reasons technical analysis faces hurdles, we still have to consult history to make sure there isn’t some magical “X factor” that chartists are picking up on that overcomes these obstacles to alpha.
A 2007 study by Ben R. Marshall, Qian Sun and Martin Young of Massey University and Fudan University found that popular technical trading rules were “rarely profitable,” but that they were generally more profitable for “smaller, less liquid stocks.” Though this result may seem to support the case for technical analysis working, they caution that “this result is not strong.”
The authors conclude, among other things, that “It is possible the behavioral biases that are inherent in the investors’ decision making process results in investors discounting the impact of consistent losses due to the large profits that occasionally occur.”
Another 2014 paper by Arvid Hoffmann of Maastricht University and Hersh Shefrin of Santa Clara University found that “technical analysis severely degrades the performance of individual investors’ portfolios.”
How badly does technical analysis underperform? Pretty badly:
“Investors who trade the most frequently use technical analysis to a disproportionate degree and underperform other investors by 4.1% per year on a risk-adjusted basis.”
The paper’s abstract alone offers a fairly severe indictment of these trading strategies:
“Our results indicate that individual investors who report using technical analysis are disproportionately prone to have speculation on short-term stock-market developments as their primary investment objective, hold more concentrated portfolios which they turn over at a higher rate, are less inclined to bet on reversals, choose risk exposures featuring a higher ratio of nonsystematic risk to total risk, engage in more options trading, and earn lower returns.”
So, does technical analysis work? In the vast majority of cases, no.
If you’re looking at guidance, look at the Forbes list. How many billionaires made their fortune day-trading stocks based on technicals?
As of this writing, John Divine did not hold a position in any of the aforementioned securities. You can follow him on Twitter at @divinebizkid or email him at email@example.com.