Thursday, November 26, 2009

A Random Walk Down Wall Street: Chapter 6

Though not exactly a book related to value investing, this oft-cited work of Princeton economist Burton Malkiel discusses many important features of stock market investing. An understanding of its prime contentions is useful for beginners and experts alike.

In this chapter, Malkiel discusses whether or not technical analysis (as described in previous chapters) actually works. The answer is a resounding no.

Malkiel himself claims not to know a single chartist who has become rich because of his investing technique, but he knows many who have gone broke. On the other hand, he knows many who have done well, not because of their technique, but because they have managed to convince others to churn their portfolios and therefore generate brokerage fees.

Anecdotal evidence aside, Malkiel cites numerous studies that have shown that while technical analysis can work some of the time (as all stock market strategies do), they do not beat buy-and-hold strategies over time. He discusses some of the more popular and elaborate charting techniques including stock price momentum, The Filter System, Dow Theory, Relative-Strength Theory, and price-volume systems. In each case, computer simulations were able to refute the claims that these patterns were anything more than random occurrences with unpredictable future results that could not beat a buy-and-hold strategy.

Despite the evidence to the contrary, why do people continue to profess to be able to tell future stock prices using past stock prices? Malkiel's answer is that humans find it hard to accept randomness. They look for patterns, even when there aren't any. Furthermore, brokerages employ technical analysts because they help speed up the churn rate in client accounts: followers of technical analysis generate far higher commissions for their brokers than do buy-and-hold investors!

Finally, Malkiel discusses some of the famous technical analysts that have come and gone including Joseph Granville, Robert Prechter, and Elaine Garzelli. The familiar pattern to each of these stories, however, is that while a technical analyst can make a name for himself with a few correct calls in a row (also likely random, as with so many people trying, there will be some successes by chance), the successful predictions are never sustained.

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