Individual investors might be best suited to stick to fundamental analysis rather than technical trading, according to a new academic study.
Those using technical analysis “disproportionately prone to have speculation on short-term stock-market developments as their primary investment objective”
“We find that individual investors who use technical analysis and trade options frequently make poor portfolio decisions, resulting in dramatically lower returns than other investors, said researchers Arvid Hoffmann and Hersh Shefrin. Individual investors who utilize technical analysis “disproportionately prone to have speculation on short-term stock-market developments as their primary investment objective, hold more concentrated portfolios which they turn over at a higher rate, are less inclined to bet on reversals, choose risk exposures featuring a higher ratio of nonsystematic risk to total risk, engage in more options trading, and earn lower returns.”
To develop their thesis, Hoffmann, from Maastricht University School of Business and Economics and Shefrin, from Santa Clara University Leavey School of Business, studied transaction records and matched survey responses of a sample of Dutch discount brokerage clients for the period 2000-2006, a limited dataset.
Technical analysis costs individual investors .50 basis points per month in diminished returns, says the study
Noting that little information is available about retail investing using technical indicators, the researchers note the most significant study on the topic occurred in 1980 with another white paper in 1997 finding that “Technical trading is much less useful for individuals, who would face much higher transactions costs and must consider the opportunity cost of the time necessary to become an expert on foreign exchange speculating and to keep up with the market on a daily basis… In addition to higher transactions costs, individual investors following technical rules also must accept the risk that such a strategy entails.”
A major finding from the study centers on those who trade options frequently and use technical analysis. For what the report calls “high derivative rollers,” it notes the “marginal cost of technical analysis from poor portfolio selection is 140 basis points, not the 50 basis points which we find for the full sample of investors, with turnover linked to technical analysis adding an additional 29 basis points of cost.”
The paper made three observations relative to behavioral finance and individual investors. The report found choices of investors was consistent with the behavior of subjects in experimental studies who use price charts, confirming the results. Second, the report found the behavioral traits of investors using technical analysis are similar to those which are linked to excessive optimism and overconfidence. Third, the study found high derivative rollers who use technical analysis and have speculation as their primary investment objective exhibit the same behavioral traits as investors who favor lottery stocks.
The report concluded that technical analysis costs 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.