Does Technical Analysis Actually Work?
Chapter 6 of A Random Walk Down Wall Street is where Malkiel stops being polite about technical analysis. He opens with a Gilbert and Sullivan quote: “Things are seldom what they seem. Skim milk masquerades as cream.”
Technical analysts study price movements and build charts to predict the future. “Hold the winners, sell the losers.” “Don’t fight the tape.” Their whole worldview says past prices contain hidden clues about where prices go next.
Malkiel’s question is simple: Does any of this work?
Holes in Their Shoes
Here’s the first thing Malkiel notices. Technicians aren’t rich. He says he’s never personally known a successful one, but he’s “seen the wrecks of several unsuccessful ones.” When you ask a broke technician why they’re broke, they always say the same thing: “I made the all-too-human error of not believing my own charts.”
Malkiel finds this so funny he made a rule: never eat dinner with a chartist. It’s bad for digestion.
He also shares a real forecast from a technical service. It basically says: if the market goes up, it’ll go up. If it goes down, it’ll go down. And if it does neither, it’ll stay the same. Even a weather forecaster can do better than that.
Is There Momentum?
The core belief of technical analysis is momentum. Stocks that are rising will keep rising. Stocks that are falling will keep falling. Just ride the wave.
Researchers tested this exhaustively. They compared stock price changes across different time periods going back to the start of the twentieth century. The correlation between past price movements and future ones? Basically zero.
Sure, sometimes you get a stock that rises for several days straight. But you also get several heads in a row when flipping a fair coin. Those streaks happen just as often in random data. What people call “persistent patterns” in the stock market occur no more frequently than runs of luck at a casino.
The Coin Flip That Looks Like a Stock Chart
This is my favorite part of the chapter. Malkiel asked his students to build a fake stock chart using coin flips. Start at $50. Heads means the stock goes up half a point. Tails means it goes down half a point. Completely random.
The chart they produced looked exactly like a real stock chart. It had what appeared to be cycles, trends, even classic formations. Malkiel showed one of these fake charts to a chartist friend. The guy almost jumped out of his chair. “What is this company? We’ve got to buy immediately. This pattern’s a classic.” He was not happy when Malkiel told him the chart was produced by flipping a coin.
The lesson: human brains are pattern-recognition machines. We see trends and cycles even in pure noise. That’s the core problem with charting.
Testing Every Technical System
Malkiel doesn’t just wave his hands. He walks through the actual test results for all the popular technical systems.
The filter system. Buy a stock when it rises 5% from a low, sell when it drops 5% from a high. Tested with filters from 1% to 50%, across different time periods and stocks. Result: after transaction costs, no better than buy-and-hold.
The Dow theory. Buy when the market breaks through its previous peak, sell when it drops through the previous valley. Result: signals had no predictive value, and the extra trading costs left followers slightly behind a simple buy-and-hold.
Relative strength. Buy stocks that are outperforming the market, avoid the ones lagging behind. Result: sometimes worked in certain periods, but not consistently. After transaction costs, not useful.
Price-volume systems. Buy when a stock rises on heavy volume, sell when it drops on heavy volume. Result: no useful information for predicting future prices.
Chart patterns. A computer scanned 548 stocks over five years looking for 32 popular patterns: head and shoulders, triple tops, channels, wedges, diamonds, the works. Result: no relationship between the signals and future performance. After costs, you’d have been better off sitting still.
The pattern is clear. Every system tested, same outcome. None of them beat buy-and-hold.
Why Your Brain Tricks You
Malkiel brings up a great example from basketball. Everyone believes in the “hot hand.” Psychologists studied every shot taken by the Philadelphia 76ers over a season and a half. No positive correlation between consecutive shots. A hit followed by a miss was actually more common than two hits in a row. The hot hand is a myth. But we believe in it because long streaks are more memorable than alternating results.
Same thing with stocks. We remember the patterns that worked and forget the times they didn’t.
The Fun Indicators
Malkiel covers a few indicators that are almost too absurd to believe.
The hemline indicator. Short skirts, bull market. Long skirts, bear market. It sort of tracked for a while. The roaring twenties had short skirts and rising stocks. The 1930s crash came with long hemlines. But it broke down after World War II. And when pantsuits took over in the 2000s? Severe bear markets. Clearly the real culprit.
The Super Bowl indicator. NFC team wins, stocks go up. AFC team wins, stocks go down. It was correct more often than not. But Malkiel points out the indicator most closely correlated with the S&P 500 was butter production in Bangladesh. You can always find two unrelated things that move together.
The odd-lot theory. Small investors (buying fewer than 100 shares) are supposedly always wrong, so do the opposite. Testing showed they weren’t actually that dumb. Following their activity generated no useful strategy.
Market Gurus: Hot Then Cold
Malkiel profiles several gurus who got famous for one big call, then fell apart. Robert Prechter predicted the 1980s bull market using something called Elliott wave theory. Celebrity status. Then after 1987, he predicted the Dow would drop below 400. He missed the entire 1990s bull run. Elaine Garzarelli called the 1987 crash with scary precision, then said the market would keep falling. It bounced back. She eventually left the business. The Beardstown Ladies claimed 23.9% annual returns. Turns out they were counting their club dues as investment profits. Real return: 9.1%, below the market average.
The moral: with enough people making predictions, some will get lucky. That doesn’t mean they’ll get it right next time.
Why Do Firms Still Hire Technicians?
If technical analysis doesn’t work, why does Wall Street keep paying for it? Malkiel’s answer is cynical and probably accurate. Technicians recommend trades. Lots of them. And every trade generates a commission. Technical analysis may not produce yachts for the clients, but it helps produce yachts for the brokers.
The Technicians Fight Back
Technicians fire back with two arguments. First, “the market isn’t random.” Second, “you haven’t tested my specific system.”
Malkiel addresses both. The random walk theory doesn’t say markets are rational. It says prices are unpredictable from past data. A drunk man staggering through a field is walking randomly. He’s not rational, but you still can’t predict his next step.
On the second point, Malkiel concedes nobody can test every scheme. But he argues something stronger: even if a system worked, it would destroy itself. If everyone knew stocks always rose between Christmas and New Year’s, they’d buy before Christmas, pushing prices up early. The pattern would vanish. Any regularity that can be discovered and acted on profitably is bound to erase itself.
The Bottom Line
Malkiel’s conclusion is direct. Past stock prices contain no useful information for predicting the future. Technical strategies are “usually amusing, often comforting, but of no real value.”
He closes with a striking statistic. 95% of the significant market gains over a thirty-year period came during just 90 of the roughly 7,500 trading days. That’s just over 1% of the total. Miss those 90 days and you wipe out all returns. If you’re jumping in and out based on charts, the risk of missing those critical days is enormous.
Stop paying for chart-reading services. Just buy and hold. You’ll save on fees, save on taxes, and probably end up with more money than most technicians.
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