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Is Technical Analysis Profitable?

Technical analysis is a method of attempting to predict future movements in stock prices based upon data about past movements in prices. For example, when you see an article or book discussing the significance of patterns found in stock price charts, the writer is using technical analysis.

As I’ve mentioned before, when considering an investment strategy, the three questions I ask are:

  1. How well has it performed in the past?
  2. Why has it worked?
  3. Why should it continue to work (even if everybody finds out about it)?

Three gentlemen recently performed an extremely thorough study in an attempt to answer question #1 regarding technical analysis.

What they Tested

They tested 5,806 technical trading rules and applied them each to 49 different countries–the 49 countries (some developed markets, some emerging markets) that make up the Morgan Stanley Capital Index (MSCI).

The trading strategies they tested were broadly categorized as:

  • Filter rules,
  • Moving average rules,
  • Support and resistance rules, and
  • Channel break-outs.

The Conclusion?

“We find no evidence that the profits to the technical trading rules we consider are greater than those that might be expected due to random data variation, once we take account of data snooping bias. There is some evidence that technical analysis works better in emerging markets, which is consistent with the literature that documents that these markets are less efficient, but this is not a strong result.”

Wow. That’s not terribly promising. But what about that bit regarding emerging markets? Is it worth exploring further? Here’s what the authors of the study have to say:

“The closest any market gets is Colombia, whose best performing rule only just fails to be statistically significant after data snooping bias adjustment.”

So if you’re looking to invest in Columbia, technical analysis is almost likely to be profitable. Everywhere else, things don’t look so rosy. Who could pass up such an opportunity for riches? πŸ™‚

One Additional Concern

In regards to my three tests above, technical analysis doesn’t seem to make it past the first one. But even if it did, I don’t see how it could make it past test #3. I don’t see any credible reason why profitable technical analysis methods should continue to be profitable once word gets out about them.

Our financial markets may not be perfectly efficient, but surely by the time I (or you, or any other individual investor) hear about reliably profitable technical analysis strategies, the big market players have already found out about them as well, thereby eliminating any hope we may have previously had of profiting from them.

Risk, Cost of Capital, and Expected Return

“The single most reliable indicator of fraud is the promise of high return with low risk.” — William Bernstein in The Investor’s Manifesto.

It’s no secret that risk and return are related.Β  But how should we measure risk? For decades, the finance community has been equating risk with volatility (often calculated and presented in the form of standard deviation).

Others, however, have argued that volatility isn’t necessarily the best measure of risk. They argue that cost of capital is a better measure of risk–a primary reason being cost of capital’s direct link to expected return.

Cost of Capital: Bond Returns

To illustrate the link between cost of capital and expected returns, consider the bond market. The interest rate a company offers on its bonds is both the company’s cost of capital and the bond buyers’ expected return. Simple, right?

And the worse a company’s credit rating, the higher the interest rate it will have to offer on a series of bonds in order to get investors to buy them. End result:

higher risk = higher cost of capital = higher expected returns.

Cost of Capital: Stocks vs. Bonds

The same relationship exists when comparing stock returns to bond returns. Capital raised by issuing bonds comes at a lower cost to the company than capital raised by issuing stock. Why? Because investors demand greater expected returns from stocks than they do from bonds in order to compensate for the uncertainty of payoff.

higher risk = higher cost of capital = higher expected returns.

Cost of Capital: Small-Cap and Value Stocks

The link between risk, cost of capital, and expected returns also explains why small-cap stocks and value stocks have historically earned higher returns than their large-cap and growth counterparts.

Start-up companies involve more risk than large, well-established companies. So it makes sense that a small-cap company has to offer investors a proportionally greater share in the company’s profits in order to raise a given amount of capital.

higher risk = higher cost of capital = higher expected returns.

The same thing occurs with value companies as compared to growth companies. If the expected returns were the same, why would you ever invest in a poorly-run company in a declining industry? You wouldn’t. And neither would anybody else. To attract capital, value companies have to offer more attractive expected returns than growth companies.

higher risk = higher cost of capital = higher expected returns.

Remember, we’re talking about expected return.

All of this is not to say that small-cap stocks will earn more than large-cap stocks, or that stocks will earn more than bonds. Over any given period, something other than the “expected” may certainly occur.

Lies from the Fund Industry

Year after year, decade after decade, the actively managed fund industry fails to deliver on its promises. Yet year after year, decade after decade, investors hand their money over to actively managed fund companies in the hopes that they’ll earn above-market returns.

Why is this? As far as I can tell, it has to do with:

  1. The structure of the industry, and
  2. How enticing and at-first-glance-believable the industry’s promises are.

Why Settle for Average?

“Wall Street cozies up to you and whispers in your ear, ‘You can do better than that…Why settle for average?'” — Bill Schultheis in The New Coffeehouse Investor

It’s such an alluring message. We don’t like being average.

And every broker (or large fund company) has data to show that they can beat the market. It’s plain as day. They’ve done it before. “Look here. See these five funds? Each of them beat the market. In fact, they each beat the market by more than 3% per year.”

Who wouldn’t invest in that? It’s a slam-dunk sales pitch when dealing with most investors.

The problems, of course, are that:

  • We’re never shown the thousands of funds that underperformed. (As Schultheis would say, the fund companies are “hiding their bad report cards.”)
  • It’s as good as impossible for the average investor to determine ahead of time which funds will outperform.

As Kenneth French (a big-name professor in the finance community) put it in this video interview:

“Stock returns are incredibly noisy. So if I’m out there trying to hire a great active manager who can pick winning stocks, looking at their track record, it’s going to be very hard for me to decide they performed so well because of skill [or] they performed so well because of luck.”

A Stock Picker’s Market

The other most common lie from the active fund industry is that “this is a stock picker’s market.” This lie comes in one of two forms:

  • “In a roaring bull markets like this, expert management can really show its value.”
  • “Our expert management will protect you in a down market.”

At first glance, either one of them seems to make sense. However, the fact that they argue that active management is especially good in both up and down markets is a clue as to the lack of truth behind the assertion.

And as William Sharpe famously pointed out, the arithmetic of active management must hold true at all times, over all periods. Kenneth French puts it this way [update: the interview from which this quote came has since been taken offline]:

“This is not a statement that over the long-haul, I expect on average to win. It’s not every five years. It’s not every three years. It’s not even every month, or every day, or every second. It’s every instant. Every instant, I know that the return on my passive market portfolio is going to be higher than the value-weighted average of everybody else.”

Once it’s framed in those terms, index investing sounds pretty enticing itself, doesn’t it? πŸ™‚

Balanced Funds in a Taxable Account

I like balanced funds and target retirement funds as much as the next guy. (Actually, I probably like them more, presuming we’re talking about low-cost ones.) But buying a balanced fund in a taxable account is generally not a good idea.

Why? Because they’re not very tax-efficient.

Taxable Bond Funds

The bond portion of a balanced fund’s portfolio is generally made up of taxable bonds (or, perhaps, taxable bond funds). Because income from bonds is taxed at a higher rate than income from stocks, you generally want to make every effort to shelter them from taxes (by putting them in an IRA, for instance).

Simplified Example: Imagine that you have $100,000 in a Roth IRA and $100,000 in a taxable account and you’ve decided that a 60/40 stock/bond allocation is appropriate for you.

One option would be to buy a 60/40 balanced fund in each account. That would be easy, and it would give you the desired allocation. Alternatively, you could achieve the same allocation, while simultaneously reducing your overall tax burden, by implementing the following asset location strategy:

  • Roth IRA: $80,000 in bond funds and $20,000 in stock funds.
  • Taxable account: $100,000 in stock funds.

This way, all $80,000 of bond funds would be sheltered from income taxes rather than just $40,000 of bond funds.

(Relatively) High Turnover

Because they rebalance so frequently, many–though not all–balanced funds have relatively high portfolio turnover. Higher turnover always leads to higher costs in terms of commissions and bid/ask spreads. And if you’re investing in a taxable account, higher turnover leads to higher taxes as well.

The reason that high portfolio turnover leads to higher taxes is that the fund’s capital gains distributions will be primarily short-term rather than long-term, and they will therefore be taxed at your ordinary income tax rate rather than the more favorable long-term capital gains tax rate. Higher turnover also minimizes the potential for delaying taxes on capital appreciation.

Foreign Tax Credit

Many balanced funds (and, as far as I know, all target retirement funds) are funds of funds. And as we discussed recently, funds of funds don’t qualify for the foreign tax credit. Granted, in comparison to the effect of poor asset location and high portfolio turnover, the foreign tax credit isn’t that big of a deal. It’s simply another strike against holding balanced funds in taxable accounts.

Update: Since the passage of theΒ Regulated Investment Company Modernization Act of 2010, this is no longer true. Funds of funds can now qualify to pass the foreign tax credit on to their shareholders.

My Suggestion

As wonderfully convenient as balanced funds are, they just don’t make sense in taxable accounts. Unless we’re talking about very small sums of money, the tax-efficiency gained by taking asset allocation into your own hands (via separate stock funds and bond funds rather than a fund that combines the two) will be well worth the effort.

For More Information, See My Related Book:

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Review: The New Coffeehouse Investor

coffeehouseinvestorcoverCourtesy of a giveaway run by Laura of Green Panda Treehouse, I recently received a copy of Bill Schultheis’s The New Coffeehouse Investor.

The message of the book is that it’s possible to invest in such a way that you can meet your goals without having to pay attention to day-to-day market movements, product pitches from brokers, or meaningless noise coming from the financial media.

Given that that’s precisely the message of this very blog, it should be no surprise that I quite liked the book. πŸ™‚

The Three Coffeehouse Investing Principles

Schultheis argues that the following common sense principles are all you really need to know in order to invest successfully:

  1. “Don’t put all your eggs in one basket.”–Diversify within asset classes and across asset classes.
  2. “There’s no such thing as a free lunch.”–Markets are (mostly) efficient. Use index funds rather than trying to beat the market.
  3. “Save for a rainy day.”–Make sure you’re saving enough to meet your goals.

I think he’s spot on with all three. (At the same time, I can’t help but be amused by the juxtaposition of principles #1 and #2, given that diversification has often been described as a “free lunch.”)

Money and Life

The book also offers sound financial advice outside of the realm of investing. For example, Schultheis is a big proponent of tracking your spending:

“I hate budgets as much as you do, but keeping track of expenses has nothing to do with budgeting and everything to do with creating an awareness of how I spend my money.”

That sums up exactly why Kalinda and I track our expenses as well. It’s not about setting restrictions. It’s about making sure that the way we use our money is actually in line with our goals and values.

Would I recommend it?

I think The New Coffeehouse Investor provides an excellent, easy-to-read introduction to buy & hold index investing. It is, however, not very heavy on facts and figures. If you’re into that type of thing, I’d suggest picking up The Four Pillars of Investing or The Little Book of Common Sense Investing instead.

And of course I won’t neglect to mention that if you buy The New Coffeehouse Investor together with Investing Made Simple, you’ll qualify for free shipping from Amazon. πŸ™‚

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