technical analysis

Technical analysis is not scientific

But it is hard to see why technical analysis should work. There is no reason why stock prices should follow regular patterns. As Burton Malkiel, a professor of economics at Princeton, argues in A Random Walk Down Wall Street: “The stock market has no memory. The central proposition of charting is absolutely false, and investors who follow its precepts will accomplish nothing but increasing substantially the brokerage charges they pay.”

He goes on to describe how he got his students to generate what looked like stock price performance charts by flipping coins. Heads meant the stock rose on the day and tails meant it fell. When Malkiel showed the resulting random chart to a technical analyst he claimed to see patterns in the price movements.

It is true that patterns can be observed in nature but there are two problems with applying a natural science model to finance. First, stockmarkets are part of the social world – created by human beings – rather than naturally occurring systems. As a result it is necessary to be cautious about applying lessons from natural science to financial markets.

Second, once patterns are discerned it is necessary to investigate why they exist. For example, Charles Darwin did not just claim that evolution existed but showed how it came about through natural selection. In contrast, technical analysts seem unconcerned with investigating why their systems should work. Their attitude seems to be pragmatic: we use our charts because they help us make money. But, as we have seen, even this claim is open to question.

One reason technical analysis remains popular is because of the limitations of fundamental analysis. It is true that investigating such factors as corporate earnings is not a foolproof way of making money on the market. All sorts of factors can influence stock prices but at least those who examine fundamentals are grounded in reality.

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