Wednesday, December 29, 2004

Technical Trading

Mahanobis talks about technical analysis and its realtionship with academic research on stock returns. The point he makes is that trend following techniques are often just attempts to utilise the serial correlations that are evident in asset prices. The academic community often refers to these as "noise trading" or more precisely "positive-feedback" strategies. The most well known is "Positive Feedback Investment Strategies and Destabilizing Rational Speculation" by J. DeLong, Andrei Shleifer, Lawrence Summers, Robert Waldmann from the Journal of Finance (1990).

There is a wide literature on behavioural explanations for the existance of "positive-feedback" strategies. Most of these are based on over-reaction or under-reaction of asset prices to news. Over-reaction can happen because of over-confidence or placing too much weight on recent information (there is good news for this stock, therefore it is a good stock, therefore I will interpret other news in a positive way). Here is an article from The Economist giving an overview of some of the ideas in this area.