The Emotionally Intelligent Investor: How self-awareness, empathy and intuition drive performance by Ravee Mehta

Author:Ravee Mehta [Mehta, Ravee]
Language: eng
Format: mobi
Publisher: LES Publishing
Published: 2012-08-23T14:00:00+00:00

CHAPTER 8

Demystifying Technical Analysis

“It is very important for me to study the details of price action to see if I can observe something about how everybody is voting. Studying the charts is absolutely crucial and alerts me to existing disequilibria and potential changes.” - Bruce Kovner, Market Wizards

In this chapter, I demonstrate why technical analysis (chart reading) can be helpful to most, if not all, types of investors. Technical analysis 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 of the biases discussed in Chapter 3. Let me begin by telling the story of how I discovered chart reading.

When I started investing in the public markets, I thought that analyzing charts was a complete waste of time. At Wharton, I learned about how a company’s market valuation was theoretically based on the present value of the free cash flow it would generate for shareholders over time. We learned almost nothing about how a stock’s historical pattern can be indicative of future performance. I tended to view stock market technicians as almost like astrologers or witch doctors. They talked in a vocabulary that seemed foreign. They talked about things such as the “inverse head and shoulders pattern” and “ascending triangles.” One word the technicians loved to say was “breakout.” I learned that this was when a stock made a new high or went above what the chartist believed to be a strong resistance level. Most technicians recommended buying after a stock “broke out.” I did not understand this. Weren’t we supposed to buy low and sell high? Why were these technicians recommending people to buy stocks that just made new highs? They were also telling people to sell stocks that made new lows. Finally, many technicians saw different patterns when looking at the same charts. This often led them to have conflicting recommendations. In A Random Walk Down Wall Street, Burton Malkiel affirmed, “Under scrutiny, chart-reading must share a pedestal with alchemy.”[lxx] It all seemed to make no sense.

I originally dismissed trying to learn anything about reading charts, but that started to change. I read books like Market Wizards and saw that many of the greatest investors actually heavily relied on technical analysis. I also started noticing that some of the best known technicians that worked at sell-side brokerage firms appeared to be right much more often than not. They seemed to be especially prescient in calling turns in the overall market. For example, many technicians turned bearish in 2000 and in 2007 well before it became clear the economy’s fundamentals were significantly weakening. Andrew Lo, a finance professor at MIT, argues that academic research of some of the rules behind technical analysis and statistical studies of the buy / sell recommendations of certain chartists appears to validate the role of chart reading. In The Evolution of Technical Analysis, Lo and co-author Jasmina Hasanhodzic state,

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