Abstract
Purpose: Stock market participants use technical analysis to seek trends in stock price charts despite its doubtful efficiency. We tested whether technical analysis signals represent typical and common cognitive biases associated with the continuation or reversal of the trend. Methodology: We compared investors’ opinions about the predictive power of technical analysis signals grouped into five conditions: real technical analysis signals associated with trend continuation (real momentum signals) or trend reversal (real contrarian signals), fake momentum or fake contrarian signals, and fluctuation signals. Findings: Investors assigned larger predictive power to real and fake signals associated with trend continuation than to signals associated with trend reversal. Fake signals, which represented cognitive biases, elicited similar predictions about trend continuation or reversal to real technical analysis signals. Originality: Market players assess momentum signals to have greater predictive power than contrarian signals and neutral signals to have the least predictive power. These results are independent of whether technical analysis signals were well-known to investors or made up by experimenters. The hardwired propensity of our brains to detect patterns combined with the non-natural environment of the stock market creates the illusion of expertise that is not easy to dispel.
Highlights
The human brain has evolved in order to recognize a variety of patterns, both spatial and temporal
The propensity to detect streaks seems evolutionarily hardwired, because false positives generated during such a process are less costly than potential false negatives (Barret, 2000, p. 31)
The propensity to assume trend continuation is highly resistant to contrary evidence (Scheibehenne et al, 2011) and requires minimal cognitive resources to operate
Summary
The human brain has evolved in order to recognize a variety of patterns, both spatial and temporal. The strong propen sity to detect patterns in time series of stock prices makes technical analysis a very tempting alternative to the passive acceptance of the unpredictable While both the propensity to look for patterns with positive autocorrelation and biased perception of randomness may explain the popularity of technical analysis, we should note that investors do not follow signals unconditionally. Technical analysis appears to be a very attractive framework for stock mar ket investors: it fits very well with our hardwired propensity to detect patterns (espe cially a continuation of trends) and seems helpful in the ex-post rationalization of investment decisions It only provides a rationale for perpetuating biases in the perception of randomness. We call such made-up signals ‘fake momentum’ and ‘fake contrarian,’ and we formulate the following auxiliary hypothesis: H3: There will be no difference in judged predictive power assigned to ‘fake’ technical analysis signals and their respective ‘real’ counterparts
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