Thursday, January 05, 2006

Is There Time for Timing?

(This is a response to a question asked by Shai to me and Bill of NoDoodahs. You can read Bill's reply from here)

Shai’s Question: What role should the exploration of stock price charts play in a value investor's intelligent analysis of equity?

When I disagree with a rational man, I let reality be our final arbiter; if I am right, he will learn; if I am wrong, I will; one of us will win, but both will profit”—Ayn Rand

When Shai asked me to become a part of this debate, I reminded myself the above quote and agreed. (Moreover there is no winner or loser, we all can learn something) I have decided to use Charlie Munger’s two-track analysis to answer the above question,

One approach is rationality—the way you'd work out a bridge problem: by evaluating the real interests, the real probabilities and so forth. And the other is to evaluate the psychological factors that cause subconscious conclusions, many of which are wrong”—Charlie Munger

Rational Consideration:
Extrapolation may give you the ability to see what’s coming down the street but not what is coming around the corner”—Henry Kaufman

The maxim on which value investing is based is ‘Margin-of-safety.’ To put it simply one tries to buy a dollar bill for, say, 40 cents and waits for the stock market to appraise it to its intrinsic value.

Instead of trying to refute the validity of technical analysis, I think it will be much more rewarding if we think in terms of opportunity cost because at the end of the day we are trying to find if technical analysis can be of any help in ‘value investing.’ Let us assume that technical analysis works and work backwards to see what effects it can have on our perfomance.

Presume that a dollar bill is selling for 40 cents and technical analysis suggests that it will fall to 30 cents. If technical analysis holds then you will buy it and end up making 70 cents. (For the sake of simplicity consider that market will quote the dollar bill at $1 sooner or later) On the other hand what if, technical analysis does not hold and you end up waiting for it to fall to 30 cents and it never does? For an extra return of 10 cents, one can end up missing upon an opportunity to make 60 cents.

Now assume that technical analysis holds 7 out of 10 times. As a result, you would have made an extra return of 70 cents, but you would have missed out on an opportunity to make $1.80. This could be the reason that one is able to find well-to-do technical analyst, but not in the Forbes list!

Thus it is fairly clear that instead of trying to make value investing complicated by linking it to technical analysis we would, rather, do well to keep it as simple as it is. This reminds me of a wonderful quote by Albert Einstein,

Everything should be made as simple as possible, but not simpler

Psychological Consideration:
What we wish, that we readily believe”—Demosthenes.

Apart from realizing that it might not be reasonable to try and predict market prices, I think it is equally important to understand the psychological tendencies that make people do that, so as to try and avoid falling prey to these biases.

Availability Bias:
An idea or fact is not worth more just because it is readily available to you”—Charlie Munger.

We have a tendency to focus excessive attention on a particular fact or event, rather than the big picture, simply because it is more visible or fresher in our mind. I am not saying that one should not pay any attention to the stock price, all I am saying is that think of the stock price fluctuations as a function of demand and supply for the stock, which varies from time to time for all sorts of reason, which we cannot explain, let alone foresee. But when we have any reason to relate price movement to changes in the business or industry we should classify it as information and make necessary changes in our assumptions.

Social Proof:
If you want to stand out of the pack, you have to stand outside the pack”—Ralph Wanger.

It is easier said than done. But if it had been that easy, everybody would have done that and in effect we would have found ourselves standing in the pack again, sooner or later [Tragedy of the commons]. So I think before jumping to conclusion that ‘majority is right,’ we should consider our actions as means to a desired end and not confuse with the fact that repeating other people’s moves will not result to that end.

Representativeness heuristic:
It has struck me that all men’s misfortunes spring from the single cause that they are unable to stay quietly in one room”—Pascal.

We have a tendency to treat events as representative of some well-known class or pattern. This gives us a sense of familiarity with an event and thus confidence that we have accurately diagnosed it. This can lead us to ‘see’ patterns in data even where there are none.

I don’t have any facts to prove that stock prices are random, but I have not come across any convincing explanation that stock prices are not random, either. Hence I think we should stick to what is provable and lies in our circle of competence. This reminds me of a wonderful quote by Ben Franklin,

There is none deceived but that he trusts”

Conclusion:
We should make sure that we realize which school of thought we belong. We either believe in technical analysis or we don’t. But please avoid taking an intermediate stand because the consequences of being uncertain about something can be worse than being certain about a fallacy. I think this is applicable not only to the current topic but generally speaking. This is very well explained by Benjamin Graham,

Where an intermediate stand is taken, the result will usually be confusion, clouded thinking and self-deception.”

5 Comments:

Blogger Value Investor said...

This is with regard to your arguments under "Rational Consideration".

As I understand them, value investing rests on the ability to spot large margins of safety, while technical analysis tries to predict small changes in price. These assumptions are implicit in your example, and in fact the example relies on this difference between the two approaches. I just wanted to state them explicitly.

Also, as a practising value investor(in India), I have found that I am not concerned about small future drops in price when it comes to purchasing a stock. Thus, if I decide, based on whatever value analysis that I am capable of, that one stock of company X is a good bargain at Rs.100, and then I see that stock trading at Rs.95, my impulse is to go ahead and buy it at Rs.95, before it decides to rise and go past Rs.100. The other possibility, that it may fall to (say) Rs.85, is a happy one -- then I can buy the stock again --, so I am not concerned about that happening. A fall in prices is a good thing.

I cannot exactly place the reasons why I feel like this. Could be something I picked up from the many readings of "Intelligent Investor", or could be a bias of some sort. But it does seem to rhyme with your reasoning here.

2:16 AM  
Blogger rajeev said...

technical analysis is a simple application of newtons law.

what start to move keeps moving, until it stops.!!

to add to it,, price moves have inter relations.

thus this knowledge with risk management gives a process to trade and time.

one can say a 1000 things why something should not happen and is useless.

i guess it doesnot takes as many things to make something work.

look at other side of coin.
ask yourself and try to post
"why technicals can work.."

ask "what useful information does price moves have in them"

what outcomes can comes and how can i defend myself when my guess is wrong.

cheers
rajeev

4:44 PM  
Blogger arpitranka said...

Rajeev:

First of all if my 'guess' turns out to be wrong, I would try not to defend myself, but correct myself.

Secondly, I firmly believe that each individual has the right to either believe in something or not, as per his understanding of the subject matter.

Moreover I think that you are in a better position to answer the questions that you have asked me, given the fact that you seem to have spent lots of time digesting the concepts of technical analysis. Also if I try to answer those question just for the sake of it, without any reasons or belief in that idea I will be doing injustice to that concept and my conscience.

Regards,
Arpit

2:27 PM  
Blogger rajeev said...

Hello Arpit
I think you mistook the line
"what outcomes can come and how can i defend myself when my guess is wrong."
for something else.

My mistake I didnot put it clearly.

I meant to say.. Technicals involves a lot of anticipation and thinking what steps to take when desired outcome doesnot turns up. (this is defending the trading capital)
As George soros said "its important to know how much you loose when you loose and how much you win when you win"..
Its important to keep the lost amount at small levels.

Also think on this

Some stocks which are really undervalued in year 2003.
Open their charts and study the patterns.

Find stocks which were not undervalued or fair valued even in 2003
and see their charts.

Open charts of many stocks of the two kind.
You would see patterns which form in first kind do not generally form in the second kind.
Why is this so?

If it was """really random""" we can expect random patterns forming all over the place.
It does not happens randomly.

The more important thing in trading is not predicting.
Its thinking what to do when X happens and what to when Y happens.
This is different from fundamental investing where we try to find value and compare with present price.

Technical trading works on a different footing and thus needs a different set of attitude and thinking than what fundamental thinking needs.

The trader knows he is using something which says the truth "sometimes". He learns how to use this imperfect knowledge of price and volume patterns to his advantage. The way a fundamental investors uses the valuations to his advantage.

Investing and Trading are different games and the logic given from the investing world that technicals is random appeass ridiculous to me.

The simple explanation is
The action of people culminates in purchasing or selling shares.
How eager the people were in their actions gets registered in charts.
and this has registration has "some" predictive value and offeres insights to those who care to look at it.

Also one has to trade the right time period and % moves using technicals.

Warren didnot said technicals donot work.
He said "it needs too much of a smartness everyday"

(in my opinion) What he meant was that trading using technicals doesnot gives him the same insight and scaling power as he gets from long term fundamental investing. The chances of making mistakes in trading remain much more, and that when you play with crores and crores of ruppee your movements itself would start to effect the patterns you try to trade.

Did he say "technicals and chart patterns are useless?"

all discussions is good cheer..

Cheers
Rajeev

4:22 PM  
Blogger COMMUNINVEST said...

As Mr Munger recommend different understanding of different Mental models. Does technical analysis be one of the many models to be consider?

3:19 PM  

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