What are they?

Behavioural finance is a field of finance which proposes theories based on psychologically based stock market anomalies. In this method, it is assumed that the information, structure and the characteristics of the market and its participants is influenced systematically. The investment decisions and the outcomes of the decisions are in a structural manner which can be studied and understood.

On the other hand, technical analysis is the method of forecasting the future price movements. This forecasting is done by examining the past price patterns and calculations thereof. But, like weather prediction, technical analysis is also not an exact science and can lead to predictions which might not prove to be true later.

Efficient Market Hypothesis (EMH)

The concept of efficient market hypothesis (EMH) has been challenged many times by the school of behavioural finance. The challenges have been presented in the form of tell tales and lack of quantification rather than hard facts. In this article, I have used some market data along with simple statistics which will prove that in the real market, certain assumptions of the EMH and mathematical finance can be disregarded.

Markov Model and Technical Analysis

The Markov model was based to develop certain theories of Technical Analysis like ‘support, resistance’ etc. For the uninitiated, The Markov model or the Markov Chain is a stochastic model a stochastic model describing a sequence of possible events in which the probability of each event depends only on the state attained in the previous event. By using market observation, it has been seen that this model actually fits the historical price data rather than the assumption that daily returns are independent and normally distributed.

Behavioural finance and Efficient Market Hypothesis

Behavioural finance was initiated as a challenge to the followers of Efficient Market Hypotheses (EMH). Later it proved instances of investor’ s behaviour that contradicted the main tenets of the EMH. The contradiction arose from the assumption that investors are rational decision makers. Also the popular assumption that at every instant of time, the price of a security reflects all the information about that particular security is also a contradiction.

So, from this we might imply that the efforts of analysts and traders to forecast and profit from the markets are useless. Also, the investors can construct a portfolio consisting of risk-free assets which suit their risk appetite. But, all of this cannot be taken into consideration. In Mathematical finance, EMH has found likelihood in the assumptions that prices are a martingale process. In probability theory, a martingale is a model of a fair game where knowledge of past events never helps predict the mean of the future winnings. This has made it possible for researchers to prove many elegant theorems of with the help of the techniques of Brownian motion. Furthermore, by taking into consideration the simple assumptions like the absence of bid-ask spread or taxes and even the homogeneity of time and the ability of investors to borrow and lend at the same rate, theoreticians have proved that dynamic hedging and options trading has become an industry in itself.

However, over the years, there has been evidence of people who had contradicted the EMH. People like Warren Buffet, Peter Lynch and George Soros who have booked millions as profits and have beaten the market year after year. The crash of 1987 and 2008 recession is also an evidence of the contradiction. Studies have shown that certain habits and hardwired biases of normal humans make it impossible for them to compete with the rational and calculated decision makers who can take any opportunity to maximize their profits. As such evidences keep getting accumulated, different flavours of efficiency were introduced to modify the stance of the various exponents of EMH. These new flavours of efficiency are the strong form efficiency, weak form efficiency etc. In all of these cases, there is a presumption that “all available information about a stock” is the total information available to the general investors and traders.

So, It can be pointed out that technical analysts or chartists do not heed to the results of mathematical finance and EMH, as these are against the principles of technical analysis. Technical analysis follows the concept that certain price patterns repeat themselves over a period of time and this can be utilised to generate profits. Consequently, technical analysts examine years of historical data and use charting terms such as support, resistance, channel, head and shoulder and momentum. But these according to the Efficient Market Theory, these terms will have no informational value. They are just used to gain a perspective into the market sentiment to identify trading opportunities. But, the approach of technical analysts towards the market is very intuitive. It suffers from a lack of quantification though certain statistical terms such as moving averages and ratios are used. Psychologists like Dr. Alexander Elder have joined into the foray of technical analysis and trading in order to justify some of these approaches and provide an explanation in terms of psychology on how the markets behave.

Thus, this difference of opinions between Behavioural finance and Technical analysis will be there in existence till there is a truce between the two. What remains to be seen is that whether these approaches can be used to make money in the markets. Afterall, in the end, making profits is what actually matters, not the method.

This article has been contributed by Prateek Mazumder, a research associate at http://www.elearnmarkets.com/.