The legendary investor Warren Buffett is well known for his long-term, fundamentals-driven approach to investing. He has repeatedly advised individual investors to steer clear of short-term speculation, market timing and following the day-to-day noise of the market. One investing approach Buffett expressly warns against is relying on technical analysis to make investment decisions. But what exactly is technical analysis and why does the Oracle of Omaha so strongly urge investors to avoid using it?
What is Technical Analysis?
Technical analysis refers to the practice of analyzing market data – mainly price and volume activity – to try and forecast the likely future direction of specific securities and the overall market. Unlike fundamental analysis, which focuses on studying the underlying business performance of a company, technical analysis is focused on the historical and current trading patterns and trends.
The premise behind technical analysis is that all known information about a stock or market, including fundamentals, shows up in the price action. So by studying price charts and technical indicators constructed using price and volume data, technicians believe they can reliably predict where prices are headed next. The field uses various signals, formations and mathematical models to generate trade signals and capitalize on perceived price trends and reversals.
The Allure of Technical Analysis
Given the complex and data-driven nature of the field, and the sophisticated charts and indicators involved, it is easy to see why some investors are drawn to technical analysis. It often appears more academically rigorous and mathematical than simple fundamental stock picking. The promise of uncovering reliable signals in the market noise and methodically profiting off them is naturally appealing as well.
Additionally, there is indeed some evidence that technical analysis can be effective under certain conditions. A segment of professional traders, hedge fund managers and algorithmic trading firms incorporate technical indicators to varying degrees into their overall trading strategies. Some trading strategies such as trend following, momentum trading, pattern trading and mean reversion have demonstrated consistent profits over long time horizons. As such, technical analysis enjoys significant popularity in the investment industry globally.
Buffett‘s Case Against Technical Analysis
Warren Buffett however makes a compelling philosophical and empirical argument warning individual investors away from technical analysis:
It promotes speculation: According to Buffett, buying stocks based on technical signals rather than underlying business value promotes speculation, which goes against his long-term oriented, "own the business" perspective on stocks.
It assumes past price patterns will repeat: While technicians interpret various chart formations as signals, in Buffett‘s view, most perceived patterns are just random market noise without any predictive power. Extrapolating such random bits of market history into the future is speculative.
It yields poor risk-adjusted returns: While some technical trading strategies like trend following can enjoy occasional strong returns, their overall risk-adjusted returns over long periods remain unimpressive according to various studies. The transaction costs, impact costs and taxes further erode net returns.
It leads to observation bias: The human brain seeks out patterns. But perceiving patterns where none exist objectively is simply a cognitive bias. This observation bias causes technicians to see confirmations of patterns everywhere, but they are just connecting the dots in meaningless ways in Buffett‘s assessment.
It promotes overtrading: Buffett is leery of unnecessary trading resulting from technical signals, since it racks up costs and taxes while likely underperforming buy-and-hold investing. The inputs and assumptions behind most technical indicators are themselves subjective in his view.
It discounts business fundamentals: Buffett‘s philosophy focuses on stocks as ownership stakes in businesses, where understanding each business‘ fundamentals, management quality and valuation is key. Technical analysis ignores all this in favor of speculative chart reading.
Buffett‘s Recommended Approach
Rather than technical analysis, Buffett strongly advocates investors put in the work to gain a thorough grasp of business fundamentals, management capabilities and intrinsic value instead. This allows making judicious investments for the long haul in high quality companies trading at reasonable valuations.
In particular, Buffett considers the 1940 book The Intelligent Investor by Benjamin Graham, widely considered the father of value investing, as the best book on investing ever written. He recommends all investors diligently study Graham‘s enormously insightful work to successfully navigate the stock market.
Unlike chasing dubious technical signals, focusing on truly understanding great businesses prevents falling victim to observation biases, performance chasing and stock market volatility. It echoes Buffett‘s famous dictum – "Be fearful when others are greedy and greedy when others are fearful."
Further Flaws of Technical Analysis
In addition to Buffett‘s primary objections, researchers have uncovered other fundamental flaws with core technical analysis premises:
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The lack of reliable backtested outperformance: While select technical trading rules have produced hypothetical historical profits, extensive data mining likely accounts for much of the outperformance rather than true predictive power. The outperformance often diminishes significantly or disappears altogether in rigorous out-of-sample testing.
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The deficiency of risk accounting: Technical models often lack robust mathematical risk accounting. Results can thus depend heavily on a few chance outlier returns, making strategies appear more precise and reliable than they truly are.
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Informational efficiency: According to the efficient market hypothesis, asset prices rapidly reflect all available information. Technical analysis aims to profit by uncovering trends and reversals in efficient markets, an inherent contradiction that makes consistent outperformance improbable over long horizons per academics.
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Non-stationary time series: Financial asset returns demonstrate dynamic statistical properties changing over time. This makes most statistical assumptions technical models make about asset price behavior invalid.
Counterarguments from Technical Analysis Proponents
Technical analysis still enjoys immense popularity among traders globally despite Buffett‘s objections and academic skepticism. Defenders counter his arguments in several ways:
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They claim Buffett‘s value investing approach still incorporates implicit technical analysis when he advocates being "greedy when others are fearful." This depends on investor sentiment indicators.
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While fundamentals may dominate pricing over long periods, human emotions introduce inefficiencies in the short run. Technical analysis aims to profit from these temporary inefficiencies before mean reversion closes the gap.
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The stock price mathematically reflects the sum knowledge about a company according to the fundamental analysts. By this logic, studying price action using technical analysis amounts to analyzing fundamentals in an indirect way.
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Certain concepts from the field of behavioral finance and chaos theory support core technical analysis premises around market sentiment, price memory, investor irrationality and price fractals demonstrating non-random structures.
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The outperformance demonstrated by popular systematic trading strategies incorporating technical inputs substantiates the potential profitability of technical analysis.
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Critics often incorrectly lump together and dismiss the field in its entirety while technical analysis today is quite nuanced and continuously evolving. Parts of it may still retain validity when applied judiciously.
Conclusion: Why Investors Should Still Side with Buffett Against Technical Analysis
While technical analysis will surely continue enjoying popularity, especially among short-term traders, Warren Buffett‘s warnings resonate deeply when it comes to long-horizon investing. Chasing dubious patterns in market noise is ultimately inconsistent with successful long-term wealth creation.
For enterprising investors with patience and discipline, there is no substitute to fundamentally understanding great businesses and the drivers of long-term intrinsic value. Numerous disciples of Benjamin Graham and Warren Buffett have enjoyed tremendous investment success by avoiding speculation and sticking to this fundamentals-focused approach decade after decade.
Ultimately there is no magical signal, chart pattern or indicator that reliably uncovers market-beating opportunities. As Buffett says, "In the short run, the market is a voting machine but in the long run, it is a weighing machine." Avoiding technical analysis and instead focusing on truly understanding businesses is key to long run returns.