A few weeks ago, I wrote an article about the relationship between (Click here to see the article)
In this article, I would like to take that discussion forward by considering the theoretical foundations of technical analysis and its merits as a method of predicting future movements.
Technical analysis (i.e. the analysis of price) begins with the assumption that there are patterns in share price which can be used to improve the ’s of making accurate predictions. If we accept that share price charts do, in fact, contain , then we need to ask the question, “Where do those patterns come from?”
The answer to that question is that the patterns originate in group. Investors as a group exhibit certain consistent behavioural patterns which can be directly linked to specific charting formations. Perhaps the easiest way to explain this is by way of an example.
The(MA) is arguably the most basic and widely used technical analysis tool. Studies done in the United States have shown that a simple 200-day moving average, applied to the over the past 100 years is approximately 10 times as profitable as a strategy. In other words, an investor who acted on every and given by such an MA over the last 100 years and paid the standard on every transaction would have made ten times more profit than another investor who simply bought the Dow Jones 100 years ago and held it over that period.
This seems to indicate that using the MA definitely improves investor performance – and that means it must be exploiting something consistent within psychology of the investors as a group whose purchases and sales give rise to the charts.
The pattern which makes MA's effective has its origins in the psychological difficulty which people have in adjusting their perceptions of asset values, quickly.
In your life, you have always thought of big-ticketas having more-or-less constant values. For example, the one of the most traumatic experiences you can have is to write off a motor vehicle – because what was worth R250 000 a few minutes ago is suddenly worth nothing. Your mind has great difficulty in adjusting to the new reality.
If I told you that your house was worth nothing you would have extreme difficulty in accepting that – even if I was right.
From a young age, we are socialized to accept that asset values change only very slowly over a long period of time – if they change at all.
Let us suppose that you have a share which is changing hands in thetoday for R20. Would you sell it for R1 tomorrow morning? Obviously not – nor would anyone be foolish enough to offer you R1. But if the share was at R20, then it is quite conceivable that you might accept R19 for it tomorrow morning. And, if you were still holding it the day after that, you might accept R18 – and, in time, it might eventually reach R1. But, it would never do so in one day – but over a period of weeks and months – which means that mathematically the share price must cut down through its moving average giving a clear sell signal.
This unwillingness to accept rapid and radical changes in the value of assets is the generalized human characteristic which allows the MA to work. It results in share prices moving in broad sweepingeither up or down – broken by occasional periods of movement. To the extent that share prices move in trends, the moving average will work and the buy and sell signals that it gives will be effective. To the extent that share prices move sideways, the moving average will not work.
With this idea in mind, two important understandings become clear:
- That technical analysis is really the study of group investor behaviour – as it manifests in share price and patterns. It follows that when you are considering a technical (like the moving average) you should try to establish which human behavioural characteristic it is exploiting because that will give you a closer appreciation of its efficacy.
- That technical analysis is really a social science in the same way as or psychology. Economics and psychology have naturally ended up in the realm of and probability, because they are striving to identify patterns within particular areas of human behaviour. Hence , economics tends towards and psychology tends towards psychometrics.
In psychology and economics, the “size of the sample” is critical. No psychologist would come to conclusions based on the study of a single individual – because that single individual might be an outlier in some way (a person with an extremely high IQ or a psychopath, etc.). In fact, the broader his study and the larger the size his sample the more compelling his results become.
So, what is the size of the sample in technical analysis? It is the volume traded. The more heavily traded a financial indicator is the more reliable it becomes technically. Thus, ashare is technically unreliable because a single investor getting in to or out of the market for reasons which are completely unrelated to the market (e.g. he sells because he needs the money to put down a deposit on a house) can move the chart significantly. But, with a share, the activities of the individual are lost in the overall direction of the trend.
Thus, a heavily traded share is more technically reliable than a thinly traded one. Anis more technically reliable than a share – and so on.
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