If you use the MACD to trade trends or the RSI to jump in and out of trades to make a quick buck, you might want to rethink your strategy.
Thousands of retail investors use technical analysis and the growing amount of real-time charting tools to invest without regard to fundamentals, deftly avoiding the messy business of calculating ROE, understanding what’s driving revenue, and figuring out forward P/E ratios in various circumstances. It sounds like a great way to make a lot of money very fast, especially if you play options where highly leveraged bets can result in doubling or even tripling your investment in just a few short days. This, in large party has been what has made Gamestop (GME) such a compelling and profitable stock to play, despite the weak fundamentals.
But does technical analysis actually work?
This question has been surprisingly under-studied. While many finance articles have looked into various market scenarios and, particularly since 2008, looked at how financial crises may impact the business cycle and the market’s pricing of equities, not much has been done on technical analysis.
What has been done is not promising.
A study of retail investors who self-report as TA driven were analyzed for the years 2000-2006. This was a period of great volatility and enough up-and-down movement to please bulls and bears, as well as enough spikes of volatility to drive market-neutral traders. With enough for everyone, you would expect the TA traders to do well.
In fact, investors who used TA had 0.5% lower returns on average than fundamental-driven stock pickers and 0.2% higher transaction costs. This means that technical analysis caused 8.4% lower performance per year.
This doesn’t stop the popularity of TA with many retail investors, who congregate on sites like StockTwits.com, as well some smaller asset managers and RIAs. There are even some TA experts who sell their chart analysis—the most popular and well-known is Kimble Charting Solutions.
It does, however, mean that less and less professionals rely on TA. While hedge funds are varied in their tactics, long/short and long/only funds do not rely on technical analysis to make decisions, and their hold periods, while often shorter than a full calendar year, are long enough to make TA relatively useless. Some smaller prop shops will encourage traders to use TA to trade more often, and of course brokerages that earn fees on trades encourage it as well, but retail investors should know that hedge funds, mutual funds, and other asset managers are increasingly relying on more fundamental analysis to deliver alpha, even if they are interested in riding trends and not finding optimally efficient prices.
While a cursory examination of a chart certainly can tell you a lot, and a closer look may sometimes tell you more, past performance is not indicative of future results. Technical analysis has been disrupted for years by the growth of algorithmic HFT shops and the growing knowledge of technical analysis itself. With so much competition, TA has become a harder way to make money—if it ever was a way to make money in the first place. This is one of a great many reasons why volumes are down, buy and hold is gaining popularity, and short-term traders are seeing their business wiping out their gains.