Most small investors who use technical analysis use it for unwise trading strategies, a new study has found. The research detailed in the paper "Technical Analysis and Individual Investors" looked at data from Dutch discount brokerage transactions and survey data from Dutch investors between 2000 and 2006.
Here's the verdict: "The findings from this study suggest that technical analysis severely degrades the performance of individual investors' portfolios," according to the paper.
The easy conclusion within jumping range is that technical analysis is a bunch of oscillating quackery. But the study didn't pass judgment on technical analysis -- just the amateur traders most likely to use it. People who are likely to use technical analysis are likely to engage in risky trading strategies.
"It is important to note that my research does not say that technical analysis per se is a strategy to avoid, and I also do not draw any conclusions about the value of different technical analysis trading rules. All we find is that investors who use technical analysis typically also have a short-term trading horizon, over-trade, under-diversify, and therefore under-perform," says Arvid O. I. Hoffmann, assistant professor of finance, co-director of the marketing-finance research lab, and director of the marketing-finance company circle at Maastricht University in the Netherlands. He's also the lead author on this paper.
In other words, don't blame the tool, blame the tool using it.
Investors are only human
According to the study, investors who use technical analysis:
- Hold more concentrated portfolios than other investors.
- Have higher ratios of nonsystematic risk to total risk. (Nonsystematic risk is the diversifiable risk associated with individual stocks or other concentrated investments.)
- Trade more frequently than other investors -- particularly with respect to options.
- Bet less on trends but are more likely to bet on the continuation of a trend versus a reversal.
- Have lower gross and net returns and lower risk-adjusted returns.
The researchers concluded that technical analysis costs individual investors "on average approximately 50 basis points per month in raw returns from poor portfolio selection decisions and 20 basis points from additional transaction costs," according to the paper.
Nothing is foolproof
The intersection of options trading and technical analysis may be where the saddest investors live. High-derivative rollers, as the paper calls them, trade options a lot and typically get 56 basis points less return than investors who are not frequent options traders.
The high-derivative rollers who use technical analysis do even worse, with 130 basis points less in returns.
Investors who try to get grand-slam returns most often have to take on commensurate risk. People can make a lot of money trading options, but most don't. So why would anyone try it? Chalk it up to uncanny levels of confidence and optimism.
"A key outcome of our work is that users of technical analysis behave in a similar fashion as overconfident and excessively optimistic individual investors in general do. In that respect, previous research finds that individual investors that trade options actively are overly confident in their market-timing abilities and underperform," Hoffmann says.
Think you can beat the odds? Decide if stock trading is right for you.
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Senior investing reporter Sheyna Steiner is a co-author of "Future Millionaires' Guidebook," an e-book written by Bankrate editors and reporters. It's available at all the major e-book retailers.