Obsessing Over Stock Charts Puts Holes In Investors' Shoes And Yachts In Brokers' Docks

Random Walk Down Wall StreetAmazonA must-read for every serious investor.

“The past history of stock prices cannot be used to predict the future in any meaningful way.”

In his book “A Random Walk Down Wall Street,” Burton Malkiel takes on a number of investing strategies, axioms, truisms, and superstitions. The central premise of Malkiel’s book is that low-cost index funds will serve the individual investor better than any other strategy for choosing stocks.

And inside of this framework, Malkiel addresses the most popular divide in stock analysis: technicals vs. fundamentals.

Technical analysis, practiced by “technicians,” uses the past price movements of stocks to determine where stocks will go next, while fundamental analysis looks at a company’s business to determine if its stock is properly valued.

Malkiel’s basic problem with technical analysis? It doesn’t work.

“For example, technical lore has it that if the price of a stock rose yesterday it is more likely to rise today,” Malkiel writes. “It turns out that the correlation of past price movements with present and future price movements is very close to zero.”

For the individual stock investor, technical analysis presents one main problem and a second more tangential one: first, after transaction costs and taxes present a challenge that makes it hard to outperform a buy-and-hold strategy; second, Malkiel says technical analysis is easy to pick on.

But even if the transaction and tax costs inherent in a technical analysis strategy that requires a lot more buying and selling of stocks than a buy-and-hold strategy, Malkiel still rejects the main premise behind technical analysis, which is that there are repeatable patterns in stock movements.

In his chapter addressing technical analysis, Malkiel presents a mock stock chart created with flips of a coin: heads goes up, tails goes down.

It looks like this:

Malkiel writes that this chart appears to display “cycles,” much like many stocks on the market today, but Malkiel argues that the “cycles” in stocks charts “are no more true cycles than the runs of luck or misfortune of the ordinary gambler.”

Why then have technicians at all?

Well, Malkiel has a few theories for that.

Malkiel writes that humans like order and people finding it hard to accept the idea of randomness, technical analysis, is able to impose a wide array of potential reasons for the random movement of stock prices.

Leo DiCaprio Wolf of Wall StreetParamount‘The Wolf Of Wall Street’ loved raking in his broker fees.

But more cynically, Malkiel sees technical analysis as a facile way for brokers to sell stocks.

Malkiel writes that most technical systems have some degree of in-and-out trading built into them, adding that “Trading generates commissions, and commissions are the lifeblood of many brokerage houses.”

“The technicians do not help produce yachts for the customers, but they do help generate the trading that provides yachts for the brokers,” writes Malkiel.

And while Malkiel, who first published “A Random Walk” in 1973, is speaking to a different era on Wall Street — a time when trades were made by calling brokers who then placed the trade at commission fees that were astronomical compared to the $US8.95 per trade investors can get through a service like E-Trade now — his general scepticism of the argument for technical analysis still holds.

“Technical strategies are usually amusing, often comforting, but of no real value,” Malkiel writes.

But again, keep in mind that Malkiel is talking about the implications for individual investors who are buying stocks, not professional investors (though Malkiel would likely argue that they ought to heed his advice as well), and not foreign exchange or commodities traders.

Technical analysis, in fact, creates much of the foundation for trading in currencies and commodities. And given that these assets lack the sort of capacity for being analysed in myriad ways like equities, technical analysis sort of becomes fundamental.

Malkiel’s target reader, however, is bound to be disappointed by adopting a complex technical framework for buying and selling stocks.

“On close examination,” Malkiel writes, “technicians are often seen with holes in their shoes and frayed shirt collars. I have personally never known a successful technician, but I have seen the wrecks of several unsuccessful ones.”

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