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Forget about Focusing on Squiggly Price Charts If You’ll Like to Improve Your Investment Returns

My American colleague Morgan Housel had recently brought to attention a piece of fascinating financial research done by two professors, Arvid Hoffmann and Hersh Shefrin from Maastricht University and Santa Clara University respectively.

The research, titled Technical Analysis and Individual Investors, studied the effects that the use of technical analysis had on the returns of Dutch investors from 2000 to 2006. Hoffmann and Shefrin summarised their findings as such (emphasis mine):

We find that individual investors who use technical analysis and trade options frequently make poor portfolio decisions, resulting in dramatically lower returns than other investors. The data on which this claim is based consists of transaction records and matched survey responses of a sample of Dutch discount brokerage clients for the period 2000-2006…

…Overall, our results indicate that individual investors who report using technical analysis are disproportionately prone to have speculation on short-term stock-market developments as their primary investment objective, hold more concentrated portfolios which they turn over at a higher rate, are less inclined to bet on reversals, choose risk exposures featuring a higher ratio of nonsystematic risk to total risk, engage in more options trading, and earn lower returns.”

While technical analysis could perhaps be useful for certain market participants, it has not seemed to work for Dutch-based individual investors (and by extrapolation, other investors around the world) as shown in the results of Hoffman and Shefrin.

I’ve written previously on another interesting study done by finance professors at the New Zealand-based Massey University in which more than 5,000 different technical trading strategies were back-tested in 49 countries. The results were somewhat shocking: None of the 5,000-odd strategies worked better than a 50-50 coin-flip. In other words, the effort spent on the study of squiggly lines might as well have been spent on flipping coins or throwing darts on a stock board.

When coupled with Hoffman and Shefrin’s study, the Massey University research has important implications on the efficacy of individual investors pursuing technical-based strategies (which in essence, is the study of historical price movements in order to divine future price trends) in order to generate positive returns in the stock market: It seems that we’ll be hard-pressed to find evidence on how technical analysis could help tilt the odds in individual investors’ favour.

For sure, the sheer number of participants in the financial markets would mean that there’ll be a lucky few who would end up with riches despite employing bad strategies (like technical analysis, for instance). But, having a bad process is dangerous and might lead to an implosion if given enough time.

How then, should investors go about participating in the stock market for better odds of success? The answer’s simple: focus on the business. As much as investors tend to obsess over every up and down tick in a share’s price, many tend to forget that there’s a living, breathing business behind every share that’s providing a good or service that customers can either love or loathe.

The billionaire investor Warren Buffett had recently wrote a great piece of advice for fellow shareholders of his conglomerate, Berkshire Hathaway. Buffett’s advice goes like this:

Games are won by players who focus on the playing field [the underlying businesses] – not by those whose eyes are glued to the scoreboard [the price chart]. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.”

Current blue-chip shares like Jardine Cycle & Carriage (SGX: C07), City Developments (SGX: C09), Singapore Press Holdings (SGX: T39), Keppel Corporation (SGX: BN4) and United Overseas Bank (SGX: U11) have gone on to give their investors multi-bagger share price gains over the past 22 years since the start of 1992 because of strong growth in their respective businesses. Spurious causations have always been an affliction of the financial markets but it’s hard to invalidate the notion that a business becomes more valuable over time as it grows its profits, cash flows, and assets.

At the end of the day, it really is the underlying business performance of a share that drives its long-term returns. Forget about squiggly price charts if you’ll really like to improve your investment returns.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares of Berkshire Hathaway.