Technical Analysis Practice: Contrast between Individuals and Professionals

• Posted by Greg Harmon
• on March 21st, 2014

There is an academic paper making the rounds that Technical Analysis and Individual Investors that is being used by many to suggest that technical analysis does not work. Here is the abstract from the paper:

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. The data on which this claim is based consists of transaction records and matched survey responses of a sample of Dutch discount brokerage clients for the period 2000-2006. Overall, 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.

That is a lot attributed to technical analysis and options trading from a study of amateurs going against professionals in levered markets.  My friend JC Parets (@AllStarCharts) has already written a nice rebuttal here which I will let stand for itself. No real surprises when you dig into the data. But what seems to be lost in this discussion is a research paper that came out about a year prior titled Head And Shoulders above the Rest? The Performance of Instituional Portfolio Managers who use Technical Analysis by David Smith, Christophe Faugere and Ying Wang. The abstract for that paper is here:

This study takes a novel approach to testing the efficacy of technical analysis. Rather than testing specific trading rules as is typically done in the literature, we rely on institutional portfolio managers’ statements about whether and how intensely they use technical analysis, irrespective of the form in which they implement it. In our sample of more than 10,000 portfolios, about one-third of actively managed equity and balanced funds use technical analysis. We compare the investment performance of funds that use technical analysis versus those that do not using five metrics. Mean and median (3 and 4-factor) alpha values are generally slightly higher for a cross section of funds using technical analysis, but performance volatility is also higher. Benchmark-adjusted returns are also higher, particularly when market prices are declining. The most remarkable finding is that portfolios with greater reliance on technical analysis have elevated skewness and kurtosis levels relative to portfolios that do not use technical analysis. Funds using technical analysis appear to have provided a meaningful advantage to their investors, albeit in an unexpected way.

There is a glaringly obvious difference in the two papers, right in the title. Individual Investors vs Institutional Investors. And if you had to guess who was better at any aspect of investing you would likely pick the professionals. But what is actually presented here is that individuals using technical analysis performed worse than other individuals not using it. Again, JC states the obvious points about short timeframes and speculation making a big difference in your performance. But where the first paper uses that data to state that Technical Analysis doe snot work, the second shows that professionals who use technical analysis do better than those who do not. The key in many ways is the last statement of the abstract. Technical Analysis as performed by professionals can be used to identify potential investment ideas like what individual investors do. But more importantly professionals use Technical Analysis for risk management. Where to put a stop loss when you know you are wrong, where in a pattern it is time to hedge a long term position, etc. I have said many times before that I view Technical Analysis as a study of supply and demand for stocks that can illuminate points of reflection for a stock, not points of certainty. In this I mean that Technical Analysis can reveal areas that the price action itself has highlighted as being important so that you as a manager can then focus on the risk. Skew and Kurtosis. Read both and make your own conclusions. Mine: Perhaps Individual Investors need to start focusing more on using Technical Analysis to manage risk and spend less time on the possible reward. I wonder where they can learn this? 😉

Get my book, Trading Options: Using Technical Analysis to Design Winning Options Trades from Amazon.

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