Evidence-Based Investing Requires Less Religion and More Reason
Technical Analysis: The Market’s Oldest Religion
During the 1600s, the Dutch had a large merchant fleet and the port city of Amsterdam was a dominant commercial hub for trade from around the world. Based on the growing influence of the Dutch Republic, in 1602 the Dutch East India Company was founded, and its evolution into the first publicly traded global corporation drove a number of financial innovations to the Amsterdam Stock Exchange, including the subsequent listing of additional companies and even short selling.
In 1688, Joseph de la Vega, a successful Dutch merchant, wrote Confusion De Confusiones, one of the earliest known books to describe a stock exchange and stock trading. Some researchers today argue that he should be considered the father of behavioral finance. Vega vividly described excessive trading, overreaction, underreaction, and the disposition effect well before they were documented by modern finance journals.
In his book, de la Vega describes the day-to-day business of the Exchange and alludes to how prices are set:
When a bull enters such a coffee-house during the Exchange hours, he is asked the price of the shares by the people present. He adds one to two per cent to the price of the day and he produces a notebook in which he pretends to put down orders. The desire to buy shares increases; and this enhances also the apprehension that there may be a further rise (for on this point we are all alike: when the prices rise, we think that they fly up high and, when they have risen high, that they will run away from us). Source
De la Vega seems to be describing how rising prices themselves can beget continued price increases. Put another way, in the words of my graduate school roommate who managed a market making desk at a large Wall Street bank, “High prices attract buyers, low prices attract sellers.”
De la Vega continues:
The fall of prices need not have a limit, and there are also unlimited possibilities for the rise . . . Therefore the excessively high values need not alarm you . . . there will always be buyers who will free you from anxiety . . . the bulls are optimistic with joy over the state of business affairs, which is steadily favorable to them; and their attitude is so full of [unthinking] confidence that even less favorable news does not impress them and causes no anxiety . . . [It seems] incompatible with philosophy that bears should sell after the reason for their sales has ceased to exist, since the philosophers teach that when the cause ceases, the effect ceases also. But if the bears obstinately go on selling, there is an effect even after the cause had disappeared. Source
Here de la Vega explicitly discusses how bulls can continue buying, and bears can continue selling, even when there is no direct reason or cause for them to do so, other than the price action itself. So here we see how, even in seventeenth-century Europe, price changes—independent of fundamentals—can affect future market prices.
While early technical analysis was evolving in stock trading in Europe, an even more fascinating financial experiment was taking place in Japan. During the 1600s, the peasant class, who made up the majority of the Japanese population, was forced into farming, thus supplying a tax base that could support the ruling military class, who in turn provided protection for agricultural land. Rice was the largest crop at that time, accounting for as much as 90 percent of government revenues, and became a staple of the Japanese economy.
The important role of rice in Japan led to the establishment of a formal exchange in 1697, and eventually to the emergence of what many believe to be the first futures market, the Dojima Rice Market. That market grew to include a network of warehouses, with established credit and clearing mechanisms.
The rapidly evolving rice market in Japan was the fertile financial environment in which a young rice merchant, Munehisa Homma (1724–1803), found himself during the mid-1700s. Homma began trading rice futures and used a private communications network to trade advantageously. Homma also used the history of prices to make predictions about the direction of future prices. But his key insight involved the psychology of the markets.
In 1755, Homma wrote, The Fountain of Gold—The Three Monkey Record of Money, which described the role of emotions and how these could affect rice prices. Homma observed that, “the psychological aspect of the market was critical to [one’s] trading success” and that “studying the emotions of the market . . . could help in predicting prices.” Thus, Homma, like Vega, was perhaps one of the earliest documented practitioners of behavioral finance. His book was among the earliest writings covering markets and investor psychology.
Homma invested on the long and the short side, and was thus an antecedent to today’s hedge funds. He was so successful and became so wealthy, that he inspired the adage: “I will never become a Homma, but I would settle to be a local lord.” He eventually became an advisor to the government, and to Japan’s first sovereign wealth fund.
On the other side of the globe, financial markets were also evolving. The late nineteenth and early twentieth centuries marked a time of increasing stock market participation in the U.S. Among the most famous equity investors of that era was a man named Jesse Livermore. He began trading at the age of 14, and over his lifetime, he gained and lost several fortunes.
An American author named Edwin Lefevre wrote the biography Reminiscences of a Stock Operator. The biography is an account of Livermore’s life and experiences in the early years of 1900s. The book describes Livermore’s success using technical trading rules. Lefevre also described Livermore’s overarching philosophy on the market:
You watch the market . . . with one object: to determine the direction—that is the price tendency . . . Nobody should be puzzled as to whether a market is a bull or a bear market after it fairly starts. The trend is evident to a man who has an open mind and reasonably clear sight . . .
We gain more insight into Livermore’s investment philosophy when we examine comments regarding his buy and sell decisions. We would recognize these decisions today as modern “momentum” strategies: “It is surprising how many experienced traders there are who look incredulous when I tell them that when I buy stocks for a rise I like to pay top prices and when I sell I must sell low or not at all.”
Clearly, the ideas that investors are not completely rational, and prices are related to future prices are not new ideas. Collectively, the investors discussed above—Joseph de la Vega, Munehisa Homma, and Jesse Livermore—highlight how great investors across history have recognized the role of psychology in the markets, and that historical prices can help predict future prices—in other words, technical analysis works. But fast forward to the early twentieth century, when some investors began to question whether technical analysis represented a sensible approach to investing. Many thought analysis of companies themselves might be a more reasonable technique. Investors began to investigate fundamental analysis, involving a careful review of a company’s financial statements, in hopes that such analysis might provide a better rationale for making investment decisions. In particular, a new investing philosophy began to gain notoriety: value investing, which involves buying stocks trading at a low price versus various fundamentals, such as earnings or cash flow.
A New Religion Emerges: Fundamental Analysis
Benjamin Graham is commonly known as the father of the value investing movement. Graham believed that if investors bought stocks at prices consistently below their intrinsic value, as determined by fundamental analysis, those investors could earn superior risk adjusted returns. Graham outlined his value investing framework in two of the most famous investing books of all time, Security Analysis and The Intelligent Investor.
Graham realized that there were many adherents to the technical analysis approach, but he was clear in expressing what he thought of the discipline: bogus witchcraft. A quote from the Intelligent Investor summarizes his views:
The one principle that applies to nearly all these so-called “technical approaches” is that one should buy because a stock or the market has gone up and one should sell because it has declined. This is the exact opposite of sound business sense everywhere else, and it is most unlikely that it can lead to lasting success on Wall Street.
Graham’s early criticism of technical analysis has been reinforced over time by other adamant adherents of the fundamental analysis religion. Graham’s most famous protégé, Warren Buffett, took the boxing gloves from Graham and continued to beat on the technical analysis crowd. A statement attributed to him demonstrates his views, “I realized technical analysis didn’t work when I turned the charts upside down and didn’t get a different answer.” A more recent quote by Burt Malkiel, who penned the popular book, A Random Walk Down Wall Street, brings the disdain for technical methods front and center: “The central proposition of charting is absolutely false . . .”
One can almost hear the laughter from the fundamental analysts. They believe they are better informed and ultimately more rational than technical investors. Another statement attributed to Buffett is, “If past history was all there was to the game, the richest people would be librarians.” It’s pretty obvious that, in Buffett’s view, only obscure and harebrained librarians turning their charts around and around would ever consider technical analysis to be a legitimate discipline. And perhaps the religious adherents of the fundamental approach thought that the use of humor and ridicule would make their arguments more compelling.
More recently, Seth Klarman, the billionaire founder of the Baupost Group hedge fund, has also denigrated technical analysis. In his cult-classic value investing book, Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor, Klarman is clear about his views:
Speculators . . . buy and sell securities based on the whether they believe those securities will next rise or fall in price. Their judgment regarding future price movements is based, not on fundamentals, but on a prediction of the behavior of others . . . They buy securities because they “act” well and sell when they don’t . . . Many speculators attempt to predict the market direction by using technical analysis—past stock price fluctuations—as a guide. Technical analysis is based on the presumption that that past share prices meanderings, rather than underlying business value, hold the key to future stock prices. In reality, no one knows what the market will do; trying to predict it is a waste of time, and investing based on that prediction is a speculative undertaking . . . speculators . . . are likely to lose money over time.
It is illuminating that Klarman views underlying fundamentals as the only justifiable signal for insight into future stock prices. Price action is “meandering” and meaningless, and efforts to predict the behavior of others are in vain. But Klarman doesn’t stop here. He goes on to reject any systematic means of predicting future stock prices:
Some investment formulas involve technical analysis, in which past stock-price movements are considered predictive of future prices. Other formulas incorporate investment fundamentals such as price-to-earnings (P/E) ratios, price-to-book-value ratios, sales or profits growth rates, dividend yields, and the prevailing level of interest rates. Despite the enormous effort that has been put into devising such formulas, none has been proven to work.
It is perhaps surprising that Graham, Malkiel, Buffett, and Klarman would be so dismissive of technical analysis, given what seems to be a rich vein of successful historical practitioners and a stack of academic research that is arguably higher than the research that supports the merits of a fundamental, or value investing, approach. Nevertheless, these fundamental investors’ views are reflective of those of many in the value investing community and of fundamental practitioners in general. The value investing religion is alive and well.
The Age of Evidence-Based Investing
Avoid extremely intense ideology because it ruins your mind.
—Charlie Munger, Vice Chairman, Berkshire Hathaway
Why did Ben Graham, a data-driven financial economist at heart, have a knee-jerk distrust for technical methods? Perhaps some of this doubt relates to how technical analysis differs from fundamental analysis. For value investors, fundamentals lead, and prices follow, albeit noisily. However, for technical investors, prices lead, perhaps even driving fundamentals, but fundamentals are not the core driver of stock movements. Moreover, the “technician” label captures a larger group of the investing public, with a much larger distribution of skills, ranging from the peon to the preeminent. This wider distribution means the average technician tends to be more subjective, less professional, and generally less sophisticated than the average fundamental investor. Thus, one criticism of technical analysis might be that investors are seeking out patterns where no patterns really exist—a reasonable concern, given what we know about human behavior.
Contrast the technical analyst with the fundamental analyst. The fundamental analyst is looking at concrete data—financial statements—which are based on established conventions. For example, positive net income ratios, ample free cash flow, and low levels of debt can be considered fairly objective measures of good financial health. Additionally, the fundamental analyst must do a lot of hard work to conduct her security analysis: after all, she is trying to identify the present value of all future cash flows from a business and discount them to the present time.
The fundamental analyst is thus arguably engaged in a more thoughtful and intellectually rigorous pursuit. In this sense, she is perhaps more credible. The number of fundamental analysts is more limited than the number of technical analysts. Buying based on fundamentals seems more reasonable than examining recent price charts with a Ouija board. The technical analyst is assumed to have a simpler job because one can reasonably argue that a history of prices is a limited and simplistic signal, whereas for the fundamental analyst, there is a much wider and deeper array of financial information to digest and consider.
But in the end, does effort and sophistication really matter? Taking a step back, the mission for long-term active investors is to beat the market. Active investors should focus on the scientific method to address a basic question: What works? Warren Buffett obviously showed that value investing, irrespective of technical considerations, can work. But George Soros and Paul Tudor Jones also showed that technical analysis can work just as well. An ever growing body of academic research formalizes the evidence that fundamental strategies (e.g., value and quality) and technical strategies (e.g., momentum and trend-following) both seem to work. Many dogmatic investors, however, looking to confirm what they already believe, selectively adopt the research evidence that fits their investing religion. In contrast, an evidence-based investor will conclude that fundamental and technical analysis strategies can work because they are two sides of the same coin. They are cousins—because they share the common objective of exploiting the poor decisions of market participants influenced by biased decision-making. As Andrew Lo, an influential and forward-looking financial economist at MIT, correctly observes about the debate between fundamental and technical traders, “In the end we all have the same goal, which is to forecast uncertain market prices. We should be able to learn from each other.”
We agree: less religion, more reason
The debate outlined above is merely the tip of the analysis iceberg and is meant to demonstrate the contentious debates that surround different investment philosophies. And as people become devoted to a particular philosophy their beliefs often become more firmly established. Thus, while ascertaining the winner in these debates is impossible, one thing is certain: Once an investment strategy has gained a convert, it is nearly impossible to “flip” that convert to another investment religion. But why do these debates necessarily need to be so contentious? Why should value and momentum approaches be mutually exclusive? Indeed, a key aspect of the scientific method is to preserve the freedom to doubt, for without doubt we would cease to explore new ideas. We argue in chapter 2 that there is an overarching framework for understanding why certain strategies work. We call our framework the “sustainable active investing framework.” This framework does not seek to identify the best investment strategy, but aims to identify the necessary conditions for any investment strategy to succeed in the future.
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Definitions of common statistics used in our analysis are available here (towards the bottom)