Behavioral Finance and Technical Analysis

Behavioral finance is a quickly growing subfield of the finance discipline. This branch of inquiry focuses on social and emotional factors to understand investor decision making. Behavioral finance studies have pointed to cognitive biases, such as mental accounting, framing, and overconfidence, which impact investors’ decisions. These studies suggest that investors often act irrationally, sometimes unconsciously, and can drive prices away from the EMH equilibrium value. Investor sentiment and price anomalies, either as trends or patterns, have been the bulk of technical analysis study. Sentiment and psychological behavior have always been the unproven but suspected reason for these trends and patterns, and human bias has always been in the province of trading system development and implementation.

The EMH is based upon a deductive reasoning process. In this deductive reasoning process, financial economists began with assumptions, such as markets are composed of rational individuals maximizing utility. Then, using logic and increasingly complicated mathematical equations, they deduce theories that must follow from the assumptions. This method is similar to that of attorneys who have a conclusion they want to convince others of by seeking evidence to support and discrediting evidence that doesn’t support it. This deductive approach results in theories, but as we have seen with the EMH, these theories do not always square with observations of real-world data because the assumptions are unrealistic and often irrational.

Those who practice behavioral finance follow an inductive approach of watching real-world events and looking for patterns. The inductive reasoning process is based on observation. It is similar to the scientific method where evidence is gathered first, regularities are observed, theories are proposed to explain, and tests are conducted to prove. A major drawback of the inductive process, however, is that just because a phenomenon has repeated itself and a pattern is detected, there is no guarantee that the relationship will continue in the future. To conclude that the phenomenon will continue to occur depends upon subscribing to a theory of why it would continue.

The deductive process has resulted in the EMH, a theory that has not been supported by observation. The inductive process of behavioral finance has resulted in a collection of observations, many which contradict the EMH, but lacks a theory to support the usefulness of these observations in the future. The evidence presented by behavioral finance supports the use of technical analysis. However, behavioral finance lacks a theory to explain why the observations occur. Without such a theory, the academic world has been slow to let go of its adherence to the EMH.

Although the divide between theory and observation remains, progress is occurring as academics attempt to develop theories that are consistent with market observations. For example, Andrew Lo (2004) applies principles of evolution such as competition, adaptation, and natural selection to financial interactions and proposes the Adaptive Markets Hypothesis. Lo claims that many of the observations behavioralists cite as counterexamples to the EMH are consistent with an evolutionary model of investors adapting to a changing environment using simple heuristics.

At this point, behavioral finance does not provide an alternative theory to the EMH, but empirical studies questioning the EMH in its purest form have bolstered the credibility of technical analysis with more sophisticated investigations of technical rules, and they have added hope that the academic world will eventually catch up to the real world of markets.

Source: Kirkpatrick II Charles D., Dahlquist Julie R. (2015), Technical Analysis: The Complete Resource for Financial Market Technicians, FT Press; 3rd edition.