On the Predictive Value of Technical Analysis

From the Market Misbehavior mailbag:

“What predictive power does technical analysis really have?  Sometimes the signals are just plain wrong.”

The short answer is that nothing’s perfect, there is no holy grail, and yet I’ve still found technical analysis to be an important piece to a holistic investment process.

Here’s the long answer.

First, in my opinion, investing is all about probabilities, never certainties.  The technical toolkit is designed to tell you what would most likely happen based on the configuration of signals at any point.  It cannot tell you what definitely will happen, but only what will most likely happen.

In his book Mastering the Market Cycle (one of my February Books for Investors), Howard Marks shared a quote by John Galbraith: “We have two classes of forecasters: those who don’t know, and those who don’t know they don’t know.”

Technical analysis is not about predicting the future.  It’s about evaluating probabilities and proper money management.

Second, there is no holy grail.  Even the most rock-solid investment process will be wrong fairly often.  I’ve worked with many investors over the years, and the ones I admire the most are able to accept the challenge that great analysis sometimes results in underwhelming performance.

Great investors aren’t right all the time.  They just admit when they’re wrong and move on.

I’ve found this to be a difficult lesson for junior analysts and novice investors, especially those used to success in school or sports or the arts.  In school, the harder you work usually translates into better performance.  In investing, that is not often a direct correlation.  Also, there’s a huge component of luck that many investors don’t want to accept or acknowledge.  We are often fooled by randomness!

Finally, Ned Davis once told me, “It’s ok to be wrong, but it’s not ok to stay wrong.”  It’s important to acknowledge when the market moves against your positions.  When it does, take proper action, and live to invest another day. 

I know from years working with institutional money managers and analysts that the best professionals are the ones who can admit when their position/call/trade is simply not working.  To do so means overcoming a series of behavioral biases, anything from confirmation bias to the endowment effect.

I will say that technical analysis is often a “truth serum” for the markets.  Forget about your well-researched and uber-thorough investment thesis.  The charts will tell you when your thesis is just not playing out.

Great investors aren’t right all the time.  They just admit when they’re wrong and move on.

My goal with Market Misbehavior is to better understand the markets from a behavioral perspective, to focus on practical tools to help market participants minimize the impact of behavioral biases, and to help investors bring a greater awareness and discipline to their process.

Technical analysis is not perfect.  But for anyone looking to upgrade their understanding of market dynamics, it’s the first place I would point them.


Disclaimer: This blog is for educational purposes only and should not be construed as financial advice. Please see the Disclaimer page for full details.