Join our community of smart investors

When technical analysis fails

Arvid Hoffman of Maastricht University and Hersh Shefrin of Santa Clara University in California have found that investors who say they use technical analysis either exclusively or in combination with other strategies have monthly returns which are 0.5 per cent lower than other investors. This is equivalent to 6 per cent per year. This finding is based on a survey of over 5,000 Dutch investors.

These losses come despite the fact that users of technical analysis are more likely than other investors to hold value stocks and are less likely to bet against momentum stocks - two things which should have improved their relative performance.

Instead, users of technical analysis are more likely to be overconfident and over-optimistic about their ability to pick stocks. This causes them to trade too much, to concentrate their portfolios and to take extreme positions in out-of-the-money options. All of this depresses returns.

However, Professors Hoffman and Shefrin found that the losses associated with using technical analysis are concentrated among a significant minority of investors - the one-fifth of them who were most active in trading derivatives. Among less active traders, the correlation between using technical analysis and returns was negative, but statistically insignificant.

This is not merely because overconfident investors tend to use technical analysis more, which would mean that technical analysis is correlated with bad performance but not necessarily a cause of it. They found that, among this minority, those who used technical analysis did even worse than those who didn’t. This suggests that using technical analysis might be a cause of poor returns because it generates dangerous overconfidence.

None of this means that technical analysis is wholly useless. It might well have a function for professional investors, who can trade very quickly at no cost and who have strong risk management tools. But, says Professor Shefrin: "technical analysis is not suitable for individual investors."