I was fooled by this cunning, seductive mistress. Technical analysis is the fools gold of finance. It is an illusion that is as real as Michael Jackson’s face. But to quote Levar Burton’s Reading Rainbow: “You don’t have to take my word for it”.

The most eye opening book I’ve ever read on finance is hands down Benoit Mandelbrot & Richard Hudson’s The (Mis)behavior of Markets. Who is Benoit Mandelbrot? He is the father of fractal geometry. A mathematician who looks at the markets as a form of organic randomness. But the markets can’t be random, can they? No. Markets are not random. However, understanding randomness is essential when judging technical analysis.

Technical analysis attempts to predict future price movements based on movements in the past. This is done through averages, equations and charts. This data is then used to determine when to buy/sell a stock.

There are a couple of problems with this philosophy.

Firstly, there are a large number of individuals who believe that the past does not reflect the future. Lets say you were thinking of buying 100 shares of Coca-Cola. What is important to you, what the stock did yesterday, last month, or last year? Or is it what the stock will do tomorrow? You probably care about the next earnings report, the next news article, the next executive decision. What happened in the past is done with and already built into the share price. The market is forward looking and all about future expectations.

The second problem with technical analysis has to do with human deficiencies in perception and randomness. It is human nature to look for patterns, even when patterns aren’t really there. In experiments conducted by Mr. Benoit, he created random charts using his fractal geometry and gave them to technical analysts with real charts using market data. The analysts were blind to the fact that some of the charts were computer generated, as they all had no identification, time, or price scales on the axis. The result? The analysts found trends in the random charts. How can randomness have trends?

They don’t. But we think they do.

Another example:

Our parent company runs a website called ConquerClub, an online game of world domination that involves “virtual dice”. When programming the dice they wanted to ensure complete randomness so the programmer turned to random.org as source for the data. Study after study has concluded that the dice rolls on ConquerClub are random. However, the largest complaint from users is that they are *positive* that the dice are in fact not random. They call them streaky.

Streaky dice & Stock trends.

It’s the same thing. An illution created by our brain in an attempt to understand randomness.

So now we know technical analysis is junk. Why is it still important?

It has become a self fulfilling prophecy. 

People are the ones making investment decisions. If many people believe that a stock will go up once it crosses a $35 dollar barrier, what happens? They buy the stock! When people buy the stock, it drives the price up and the system works! Another successful technical analysis prediction.

So go on looking for trends you crazy technical analysts, you control your own destiny.

Contrarians are not the ones shouting from atop desks, playing silly sounds and acting like crazed lunatics when discussing the stock of the day. In fact, one could argue that a contrarian is the exact opposite of Jim Cramer.

That shouldn’t really surprise anyone. After all, Jim Cramer is the most popular investment personality on the most popular investment television station. A contrarian prefers to act in the opposite from the conventional norm, and as weird as it sounds, Mr. Cramer is as norm as you get.

I myself have fallen victim to the same trap of ignoring the contrarian. A perfect example of this was my recent discovery of iTulp.com, a website dedicated to the contrarian view of investing. This website has been around since 1998, an eternity by web standards. It has been written up by very credible news agencies, varying from Barron’s to CNBC. Impressive. I am, however, not alone in my ignorance in knowledge of this website. Alexa ranks iTulip outside its top 100,000 sites. I have seen many sites in existence for less than a year easily crack the top 100k.  Therefore, many people appear to be ignoring the Contrarian, hence my post.

Perhaps the most famous, if not the simplest contrarian strategy is the Dogs of the Dow. It is also the first investing strategy that I read about, so I will always hold a special place for it. The premise couldn’t be simpler. At the end of the calendar year purchase equal dollar amounts of the 10 Dow Industrial Average stocks that have the highest dividend yield (the dogs). Hold for a full year and re-balance annually. The theory is that your returns will outperform the full 30 stock Dow Index. It didn’t work the year I tried (on paper).

Even though my first experience with contrarian strategy was a failure, I still believe in reading up on what contrairans are currently talking about. They are often very smart people who make astute arguments on where the market has been, currently is, and will be heading. I encourage you all to do a bit of research and study this methodology. You might not agree with their outcomes, but there are definitely some nuggets of knowledge that will benefit you in future investments.

After reading a heated discussion in a personal finance forum earlier this week, I thought it would be a great idea to write my thoughts on one of the most intensely debated and discussed issues in finance. This is a question that I ask MBA grads during 1st round interviews. You’d be surprised how often very smart people can sound very stupid when asked if markets are efficient, and what to do about it.

There are two basic schools of thought in regards to investing in the stock market. In one corner we have the active investor. She believes that markets are inherently inefficient. An inefficient market is one where prices do not accurately reflect the value of an asset at that point in time. Therefore, some stocks will be “cheap” and others “expensive”. The goal of the active investor is to purchase the “cheap” stocks and then sell when they match/exceed their true value.

On the flip side we have the passive investor. He believes that the market is efficient and all prices accurately portray the true value of an asset. There are no “cheap” stocks. Everything is priced to perfection for that point in time. Depending on how far the investor is on the passive scale, they either base purchases purely on future expectations, or opt for the ultimate in passive investing: indexing.

Which is the better approach?

Both have pros and cons and I will try to point out just a few as some food for thought. Since this is such as touchy and personal subject, I know many will disagree with me and I encourage you to sign up and debate it out in our new forums.

Firstly: Are markets efficient?

No.

No, they are not. They never were. They never will be. If every human acted like a robot, then maybe they would be. Humans are not robots (yes, even the one’s at MIT) and do not all react to produce the same output when given an identical input. My favorite example is the after hours equity market during earnings season. When a company reports its earnings, investors are given some time to digest the news before trading is allowed to resume. What often happens are huge price fluctuations as the market “feels itself out”. The next morning when regular trading resumes, the stock can end up going in the complete opposite direction from the night before. How is that logical? Every participant got the same information at the same time. If the market was truly efficient, the pricing should be relatively stable after the news was made public.

Active Investing
Pros

• More fun – This might seem like a silly and illogical pro. People invest to make money, not for fun! That’s not really true though. Most active investors love the thrill of researching companies in order to find the gems that they believe will make them money. It can be fun, although potentially misleading.

• Diversification – Through active investing, you can create custom portfolios that provides hedges and diversification that can insulate a portfolio from market instability.

Cons

• It usually doesn’t bring better gains. When looking at the performance of money managers over the long run, the vast majority under perform the index. There are often specific reasons for this, I’ll leave that for another feature.

• Cost. Running an active portfolio often results in more transactions and different positions, creating a larger costs through commissions and fees.

Indexing (The ultimate passive approach)

Pros

• Easy. There’s no research to do. Just pick up an Indexed product and hold it.

• Cheap. Fees on indexed products are significantly lower than active products.

• Performance. The index will outperform most managers, so why even bother with the high fees and lower performance?

Cons

• Diversification Risk. Indexes are not perfect diversification tools. Sometimes the weighting of a sector or even a specific stock can cause a massive skew in the composition of the index. One stock or sectors collapse can cause massive damage to the index and your portfolio.

In the end, it really depends on which strategy suits what kind of investor. If you don’t want any professional help and don’t have the time to research, then indexing might be your best bet. If love the thrill of stock chasing and picking, you’re probably already an active investor.

Best of Luck!