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Challenging of the technical analysis is two-fold: skeptics first question technical analysis assumptions, and then specific trading rules and their long-term value.
Before proceeding to challenges presented before technical analysts, let's first discuss why technical analysis has a relatively huge and very loyal fan base. For starters, although technicians generally acknowledge the value of fundamental analysis, they are skeptics when it comes to quick and correct processing of new information. If for no other reason, technical analysts find themselves in an advantageous position for not having to rely on financial statements (at least not heavily). Also, technicians believe they do not need to estimate assets’ intrinsic values in order to recognize that an asset might be shifting towards a new equilibrium. All that is needed is close monitoring of the shifts in price and volume trends and the resulting effects. Technical Analysis Assumptions under FireThe most often quoted challenge of technical analysis is based on the findings of the efficient market hypothesis studies. As discussed in the article EMH and Technical Analysis, the weak form efficient market hypothesis concluded that technical analysis is mostly incapable of generating above-average returns. First, the weak form EMH tests have failed to differentiate between returns realized based on trend analysis and the so-called “random walk.” And second, analysis of specific trading rules has also failed to demonstrate returns above the “good-old” buy-and-hold strategy. Questioning Technical Trading RulesThe first and the most obvious challenge thrown before technical analysts is their reliance on the past price movements, as well as the relationship(s) that may exist between a number of variables used in predicting future price movements and trends. Furthermore, another problem arises from the so-called “herd mentality syndrome.” Even if correct predictions of future price movements were possible based on past performances, these are highly likely to attract hoards of investors who could quickly learn to exploit these anomalies. Therefore, it stands to reason that popularity of trading rules tends to neutralize any benefits such strategies could potentially yield. In addition, it has been noticed that investors tend to focus on one preferred trading rule that may have helped them in the past to correctly anticipate changes in price patterns. But before any such change could even have time to materialize, numerous other and just as eager investors would “jump the gun” and either spoil the prospective development of the expected price pattern or eliminate any potential profits for other investors anticipating the fruition of the same trading rule. One of the more obvious examples of the above-mentioned focus on one specific trading rule are the rules concerning the short-selling data, which technicians have managed to exploit in the past to generate higher rates of return. However, in recent years, these trading rules have become so popular with the general investing public that their variations have already managed to morph into something very different from the original rules, thus rendering them more or less ineffective in the process. Finally, technical analysis greatly relies on whatever may be held in the proverbial eye of the beholder. In other words, technical analysis requires too much of a technician’s subjective perspective to be widely accepted as either reasonable or reliable. For instance, it is quite possible for two traders to look at the same chart and arrive at different conclusions. This obviously implies that technical analysis cannot be used on autopilot and thus, it is anything but obvious. So far, many old technical trading rules have either completely changed or have been abandoned because they simply became ineffective. (This article is part of a series. Access the next article in the series by following this link.) Sources: Investment Analysis and Portfolio Management, Eighth Edition, by Frank K. Reilly and Keith C. Brown, 2005 Optional reading: Chart School at www.stockcharts.com
The copyright of the article Challenging Technical Analysis in Investment is owned by Inya Ivkovic. Permission to republish Challenging Technical Analysis in print or online must be granted by the author in writing.
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