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WHY Technical Analysis Works!

Most technicians who write about their methodologies think that people should follow them just because of the results.  They spend very little time explaining why chart reading seems to work.  In this short blog post I try convince you that technical analysis is useful because of our behavioral biases.

A support level on a stock chart is the result of our bias to sell winners too early and our inclination to make associations with prior positive outcomes.  Imagine several people, who originally bought IBM near $160 and sold it at $180.  They each experienced a positive outcome.  Most of these people will create a mental shortcut that associates buying IBM around $160 with a positive feeling.  Therefore, $160 becomes a support level.  In fact, this association can be so powerful that they can ignore facts such as a deteriorating outlook for the company’s fundamentals or negative changes in the economy.  Likewise, a resistance level on a stock chart is the result of the human self-defense mechanism against feeling the shame of being wrong.  A resistance level is created when there are many holders anxiously waiting to sell for a lucky escape once they get back to a price that would yield a ‘break-even’ result or a slight gain.  Imagine many people, who bought shares of Research in Motion (RIMM) at $15 because they were hopeful the company would turn its business around with new product introductions.  After RIMM’s new products got bad reviews, some of these people sold, causing the stock to drop sharply.  Those who didn’t exit, likely now feel stuck.  They desperately want to avoid the shame that comes from selling at a loss, so they continue holding on to losing positions.  They hope for a bounce back to $15, so that they can exit and break-even.  Thus, $15 becomes a resistance level.

Another common technical principle is that the stock market tends to bottom out as fewer stocks in the market make new lows.  This “market breadth” rule makes sense when one considers the human bias to overly focus on a “win/loss” ratio.  Most of us are biased to look at the number of times we are right versus the number of times we are wrong.  Of course, this is absurd.  In investing, you can have many winners which can be more than offset by a single loser.  Nevertheless, when people see that most stocks in their portfolios are not making new lows, they tend to get a little happier, even if they are still losing money.  The improved mood generally leads to increased risk-taking (There is a lot of academic research which shows that risk appetite rises as people become happier).   Mood is also contagious, so when some get happier, others are likely to follow with increased risk-taking.  The shift in mood among many market participants eventually leads to an inflection from a bear market to a bull market.

Technical analysis (chart reading) can be helpful to most, if not all, types of investors.  It works because it takes account of investor psychology.  A chart can tell you a tremendous amount about what the current shareholders of a security may be feeling.  It can be a visual manifestation of many behavioral biases.  If you are an investor, who compares chart reading to astrology, you are missing out.  I know, because I used to be in your camp.  Similarly, traders, who focus too much on esoteric patterns without understanding what the chart is actually telling them, are also often using technical analysis incorrectly.

Much more on this topic, including a discussion of several other chart reading principles, in my recently published book: “The Emotionally Intelligent Investor: How Self-Awareness, Empathy and Intuition Drive Performance” available at http://www.amazon.com/The-Emotionally-Intelligent-Investor-self-awareness/dp/0615688322

–          Ravee Mehta, Investor and Author

–          Follow me on twitter @ravee_mehta

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