Technical analysts believe stock prices follow predictable patterns that can be seen in historical price charts. However, academic research shows prices behave randomly and past prices cannot reliably predict future movements once transaction costs are considered. Many technical trading strategies do not outperform a simple buy and hold approach. While technical analysis remains popular, the evidence suggests its predictions contain no useful information.
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Random Walk Theory Beats Technical Analysis
1. A Random Walk Down
Wall Street:
The Time-Tested Strategy for Successful Investing
by Burton G. Malkiel
Chapter 6: Technical Analysis and the Random-Walk
Theory
Ahmet Kadir Tunsay
113613
Abigaelle D.
Kenmogne
2. Technical Analysis and The
Random Walk Theory
• Not earning , nor dividends, nor risk, nor high interest rates
stop the chartist from their assigned task: studying the price
movements of stocks!
Chartist are individuals that use
charts and graphs of historical
prices or levels to forecast future
trends, they believe that the
price movements in a security
are not random, but can be
predicted through a study of past
trends and other technical
analysis.
Technical Analyst created
Wall Streets most colorful
theories and folk language;
“Hold the winners, sell the
losers”, “Switch into the
strong stocks”, “Sell this
issue, its acting poorly” but
don’t forget that technical
analyst collect their
brokerage fees for churning
your account.
3. Who are the Technical Analysts ?
• Technical Analyst observe patterns of the stock
market by using graphs and charts of historical
data to make predictions about its future
performance.
• They build there strategies upon dreams of
castles in the air (extravagant hopes and plans)
and expect their tools to tell them which castle is
being built and how to get in on the ground floor.
• The question is: Does technical analysis work?
4. If you’re so smart, why aren't you rich?
• According to Burton G. Malkiel he has never
known a successful technician that follows his
own technical advice, but seen several
unsuccessful ones.
• Broke Technician:
They are never apologetic. You ask them;
Why are you broke?
Answer: I didn’t believe my own chart?!
5. Technical analysis is strongly disliked
by the academic world. Why?
1. After paying transaction costs, the method does
not do better than a “buy and hold” strategy for
investors.
2. Its easy to pick on!
It is easy to test all technical trading rules on the
computer, it has become a favorite pastime for
academics to see if they really work.
P.S. We are trying to save your money!
6. Is there momentum in the stock
market?
• In finance, momentum is the empirically observed
tendency for rising asset prices to rise further, and
falling prices to keep falling.
Chartists (Technicians):
• They believe momentum
exists in the market and
that there are repeatable
patterns in space and
time. (Basic premise)
Economist (Mathematicians):
• They believe that stock
prices behave very much
like random walk.
• Why?
7. Result: Past movement in stock prices CAN NOT be used reliably
to foretell future movements. Chartist are FALSE and investors
who follow will accomplish nothing but brokerage charges to pay
which may increase dramatically.
9. Mathematicians:
• They call a sequence of numbers produced by a random
process a random walk. The next move on a chart is
completely unpredictable on the basis of what has happened
before.
• To a mathematician, the sequence of numbers recorded on
a stock chart behaves no differently from that in the
simulated stock charts with one clear exception. There is a
long-run uptrend in most averages of stock prices in line with
the long-run growth of earnings and dividends. After
adjusting for this trend, there is very little difference. The
next move in a series of stock prices is largely unpredictable
on the basis of past price behavior. No matter what wiggle or
wobble the prices have made in the past, tomorrow starts
out roughly fifty-fifty. The next price change is no more
predictable than the flip of a coin.
10. Some More Elaborate
Technical Systems
• The Filter System: (Percentage Changes in price)
A stock that has reached a low point and has moved up,
say 5% is said to be in an uptrend and a stock at peak
and moved down 5% is a downtrend.
Buy a stock when moved up 5% from low point and hold
until the price moves down 5% from a subsequent high,
and then sell.
Very popular with brokers. Filter method is basically “stop
loss” where the client is advised to sell his stock if it falls
5% below the purchase price to “limit his potential
losses”.
11. The Dow Theory:
• A theory which says that the market is in upward
trend if one of its averages advances above a
previous peak so we should buy, and sell when it
sinks through the preceding valley.
• The markets performance after sell signals is no
different from its performance after buy signals.
This is why there is no significance for predicting
future price movements.
• Transaction cost/brokerage cost may be extremely
high.
13. The Relative-Strength System:
• In the relative-strength system an investor buys and
holds those stocks that are acting well, that is,
outperforming the general market indices ( S&P 500)
in the recent past. Conversely, the stocks that are
acting poorly relative to the market should be avoided
or, perhaps, even sold short.
• Nevertheless, a computer test of relative-strength rules
over a twenty-five-year period suggests that such rules
do not, after accounting for brokerage charges,
outperform the buy-and-hold investment strategy.
14. Price-Volume Strategy:
• Suggest that when a stock rises on large or increasing
volume, there is an unsatisfied excess of buying
interest and the stock can be expected to continue its
rise.
• When a stock price drops on large volume, selling
pressure is indicated and a sell signal is given.
• The buy and sell signals generated by the strategy
contain no information useful for predicting future price
movements.
• The investor is obliged to do a great deal of in and out
trading leading to a lot of transaction cost. A diversified
group of stocks would be better.
16. A Gaggle of Other Technical
Theories to Help You Lose Money
• Once the academic world polished off most of the
standard technical trading rules, it turned its august
attention toward some of the more fanciful schemes.
• The world of financial analysis would be much quieter and
duller without the chartists, as the following techniques
amply demonstrate.
• The 3 Techniques;
1. The Hemline Indicator
2. The Super bowl Indicator
3. The Odd Lot theory
17. The Hemline Indicator
• Not content with price movements, some technical
analysts have broadened their investigations to
include other movements as well.
• One of the most charming of these schemes has
been called by Ira Cobleigh the "bull markets and
bare knees" theory.
18. • There does seem to be a loose tendency for bull markets to be
associated with bare knees, and depressed markets to be associated
with bear markets for girl watchers.
19. The Super Bowl Indicator
• The Super Bowl indicator forecasts how the stock
market will perform based on which team wins the
Super Bowl.
• A victory by an NFL team predicts a bull market in
stocks, whereas a victory by a former AFL team is bad
news for stock-market investors.
• Why did the market go up in 1997?
• Because the Green Bay Packers defeated the New
England Patriots in 1997, the auguries for a stock-
market rise were good; again, the market responded
correctly by rising smartly.
20. The Odd - Lot Theory
• The odd-lot theory holds that except for the
investor who is always right, no person can
contribute more to successful investment strategy
than an investor who is known to be invariably
wrong.
• According to popular superstition, is precisely that
kind of person. Thus, success is assured by
buying when the odd-lotter sells and selling when
the odd-lotter buys.
• Odd-lotters are the people who trade stocks in
less than 100-share lots (called round lots).
21. Technical Market Gurus
• Joseph Granville was one of the most widely followed
forecasters of the early 1980s. His record had been good for
a time in the late 1970s, and at his heyday he had the power
to move markets.
• Robert Prechter became interested in the parallels between
social psychology and the stock market while a Yale
undergraduate.
• Elaine Garzarelli, an executive vice-president of the
investment firm of Lehman Brothers. She uses financial
data.
• Mid-1990s were the homespun, grandmotherly (median age
70) Beardstown Ladies. Called by publicists "the greatest
investment minds of our generation," these celebrity
grannies cooked up profits and hype.
• 1990s, Abby Joseph Cohen of Goldman Sachs.
22. Moral of The Story:
• With large numbers of technicians predicting the
market, there will always be some who have
called the last turn or even the last few turns, but
none will be consistently accurate.
• "He who looks back at the predictions of
market gurus dies of remorse."