This article is an excerpt from the Shortform book guide to "A Random Walk Down Wall Street" by Burton G. Malkiel. Shortform has the world's best summaries and analyses of books you should be reading.
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What is the best method for predicting the movement of stock prices? Does technical analysis work?
Technical analysis uses the past movements of stock prices to predict future prices. For example, if a stock has risen over the course of a day or several days, a technical analysis will show confidence in the stock. Technical analysts argue that stock prices tend to follow trends, meaning they can sometimes be susceptible to the irrational optimism of other investors.
Does technical analysis work? Find out below.
Does Technical Analysis Work?
Does technical analysis work? The answer to this question is complicated. On the one hand, portfolio managers argue that technical analysis does work. But, the evidence seems to suggest otherwise.
As established by their role in speculative bubbles, professional portfolio managers, for all their experience and expertise, are as susceptible to castle-in-the-air thinking as the rest of us. “But,” a portfolio manager might say, “in the long run and on average, we manage risk for our clients and provide returns that beat the market—that’s why so many Americans trust us with their life savings and why we deserve our fees and commissions.”
Unfortunately for portfolio managers, academics have compared managers’ returns with those provided by a market index fund—a mutual fund with holdings that replicate a market index—and found that portfolio managers simply aren’t worth the money. That is, no investor can do better in the long run than a market index fund.
Why can’t portfolio managers consistently outperform index funds? Fatally flawed methods of analysis.
What Is Technical Analysis?
Security analysts typically use one of two methods for predicting the movement of stock prices: fundamental analysis and technical analysis.
Technical analysis relies on stock charts—graphs of past price movements and trading volumes—to predict future price movements. (Because of their reliance on charts, technical analysts are also called “chartists.”) Technical analysts subscribe to the castle-in-the-air theory of asset valuation: They believe that stock prices are more a product of investors’ psychology than a sober accounting of a firm’s profit-making potential.
Technical analysts adhere to two primary principles: (1) that all economic data—revenues, dividends, and future performance—are reflected in a stock’s past prices; and (2) that stock prices tend to follow trends (if a price is rising, it will continue to rise, and vice versa). It’s completely inconsequential to the chartist what industry a company is in or what’s happening in the world at large. To the chartist, all that matters is past and future price changes.
In practice, what this means is that technical analysts will study a stock’s charts to deduce trends. If there’s an “uptrend”—in other words, the stock price has risen over the course of a day or several days—then the chartist will be bullish on the stock. A head-and-shoulders pattern—where there’s a rise and fall, a greater rise and fall, and then a rise and fall similar to the first—indicates that a stock may have reached its “resistance level” and is due for a downturn. But does technical analysis work? Here’s why it might.
Does Technical Analysis Work? A Case for Technical Analysis
Despite its seeming arbitrariness, technical analysis does indeed have a logic.
- Technical analysts bank on mass psychology. They presume that when investors see a stock rising, they’ll hop on the bandwagon, driving the price even higher.
- Technical analysts assume unequal access to information. If a price is rising, chartists theorize that company insiders or more expert observers know something the wider market doesn’t and are driving up the price by buying stock.
- Technical analysts believe prices have a delayed reaction to new information. Some research suggests that when “earnings surprises,” either good or bad, for a company are announced, the price will react immediately but incompletely. That is, when a stock initially declines due to lower-than-expected revenues, it’s actually only just beginning its downward slide. Thus, when a chartist sees downward movement, he or she may be justified in assuming the price will continue to fall.
A Case Against Technical Analysis
So does technical analysis work? The short answer is no. Academics studying the financial world and the performance of portfolio managers have determined that technical analysis—which requires a high volume of trading as stock prices rise and fall (which in turn entails considerable commissions and fees)—does not result in a greater return than a “buy-and-hold” strategy (as epitomized by a long-term investment in an index fund).
One of the technical analyst’s core principles is that price trends tend to be self-fulfilling—that is, if a stock’s price is rising, it will continue to rise for no other reason than the trend itself.
Researchers have found, however, that a stock’s past doesn’t reliably indicate its future. (Shortform note: Anyone who has read a fund’s prospectus will have seen the disclaimer that “past performance is no guarantee of future results.”) Although there’s some evidence to suggest there are brief spells of market momentum, there are just as many sharp reversals in momentum.
When enough price data is compiled, what researchers have discovered is that stock prices resemble a “random walk”—a mathematical concept that describes a value moving randomly up or down in a succession of “steps.” A classic example of a random walk is flipping a coin: If one is using a fair coin, there’s always a 50% chance one will flip either a head or a tail. The outcome of the flip is always random, and previous outcomes have no effect on present or future outcomes.
Although stock prices don’t conform precisely to the mathematical random walk—Malkiel calls market movement a “weak random walk”—enough comparative research has been done to establish that technical analysis doesn’t consistently outperform buy-and-hold strategies.
As noted above, technical analysis requires investors to engage in a high volume of trading—investors must always be ready to sell at a market peak and buy when the market is in a trough.
There are two major problems with this mode of investing:
- High-volume trading entails commissions and taxable capital gains. Although commissions are less of a concern now, with many brokerage services offering commission-free trades, immediately realized capital gains may be subject to heavy taxes. (Whereas, if you hold the stock for a long period of time, you may see a similar gain without having to pay the tax.)
- Market gains happen in short and unpredictable bursts. One scholar found that, over a 30-year period, 95% of the market’s gains occurred on 90 of 7,500 trading days. If a technician happened to be sitting in cash on those days—due, perhaps, to a low-hemline fad—he or she would have missed enormous opportunity. In other words, it pays to buy into the market and stay there.
So, does technical analysis work? The evidence suggests it doesn’t.
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