April 30, 2009
I've written before about the Efficient Markets Hypothesis that, in a nutshell, says that technical analysis does not work. The reason, goes the theory, is that looking at past information such as price and volume is useless because all of the past information is reflected in the current price. This theory by the way has been confirmed in many academic studies. The question then becomes, why do so many people use and swear by technical trading? The answer is easy: it seems to work. Of course, whether it's real success or confirmation bias is another story, but I'm going to assume it's real.
So how do strategies that aren't supposed to work actually work? The reason, I'm beginning to think, is precisely because so many people use them. If lots of people think that a particular price chart is giving a buy signal for a stock, then they will go buy it, and if enough people go buy the stock, the price will rise. The signals from the chart are meaningless in and of themselves, but all of the people using the information cause real price movements.
A good example is the use of "resistance levels" which are prices that are considered to be significant, in that if the price moves above the resistance, the price is supposed to continue to rise. The resistance, like the rest of technical analysis, is purely psychological. The price moves above the recent highs and traders assume it will continue to rise. In the sense that people are the causes of price fluctuations from buying and selling, and that people are driven by psychology, perhaps technical analysis should be considered more important than fundamental analysis, which actually looks at the company itself. You don't ask the car why it drove across town, you ask the driver. And what drives the drivers is an important question if one wants to understand the movement of cars. Or stocks.
I've heard it said that technical stuff drives the short term, but fundamentals drive the long term performance. It's similar to Ben Graham's "Mr. Market" - the psychology might be all over the place, doing its own thing, but the fundamental guys should use that to their advantage.
At any rate, even though I generally tend to think EMH is probably correct, it's easy to see how psychology can affect price. Which means that even if you subscribe to EMH, you may not want to be quite as passive as MPT would have you be. That's what me and my small brain have been thinking lately.
Comment by: matt g at 4:32 PM, April, 30, 2009
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