The New Science Behind Stock Charts

US News

Those crazy-sounding chart formations like "death cross," "cup and handle," "dragonfly dojo" and "falling knife" that stock traders wave about on graph paper sometimes sound as scientific as divining rods or wishbones. But behavioral finance is unearthing growing evidence that shows those wild-eyed technical analysts are not just reading astrological charts and have one thing scientifically right: Plotting stock prices visually leads to better investing decision-making.

The stock market has been gaining this year with help from one important chart signal - the level of market "exuberance" as seen in buy and sell patterns and market volume. "It has been a market rally that has been avoiding excesses," says longtime technical analyst Philip Roth. This behavior points to more gains, he adds, but a lack of enthusiasm - a healthy sign for now - could eventually derail the rally.

Purging passion from market decision-making is one of the basic rules chart followers live by. They see the market as a virtual animal whose moves can be read through the emotional extremes of fear and greed, which comprise market sentiment at a given point in time. They point to the work of MIT finance professor Andrew Lo, whose behavioral psychology experiments and long-range studies have shown the impact of these animal spirits.

[Read: 12 Reasons Not to Fear a Market Bubble.]

Studies of such market dynamics have "already demonstrated an ability to understand many aspects of financial markets," wrote Lo in a recent paper on efficient markets, although he adds that the science is "in its infancy." He studied day traders and hedge fund managers in depth, using tools of neuroscience and behavioral studies to show that markets are ruled primarily by emotions, challenging the long-held view that they price stocks based on information alone.

But other researchers warn against basing your next stock market purchase on what today's "pitchfork" or "ascending triangle" might say, because charts alone don't inoculate against the risks of emotional decision-making.

Other behavioral science studies find the limits of such tools. Duke neuroscience and psychology professor Scott Huettel has done research that shows people often see patterns that are not there, or that others do not see in the same way that would produce a meaningful buy or sell signal. "People are very good at thinking they see trends that don't mean anything in just a random sequence of numbers," Huettel says. "You really cannot predict things that way."

So what has behavioral science shown that those charts are good for? This, at least: Information presented visually is a lot better than a bunch of numbers, behavioral scientists have found.

Anya Samak, now an assistant professor at the University of Wisconsin School of Consumer Science, ran an experiment while doing research at the University of Chicago in which she gave theoretical cash amounts to students to invest in the market. Those with access to visual data ended up with significantly more cash in their portfolios.

The use of visual tools helps counteract information overload and complexity, she says, and "enables users to interactively discover information from large information sets to improve the financial decision-making process." Her work also suggests people gain confidence and base decisions on a wider range of choices when using visual data.

[Read: How Investors Can Avoid the Market Bull Whip.]

Behavioral psychology studies suggest the value of presenting data visually, but only as a tool in making an informed decision. Indeed, David Littlejohn, chief technical analyst at BigFoot Investments, says charts are extremely valuable in making investment choices, but technical analysis alone does not work. It's just one tool to use along with a full view of a company's earnings and business fundamentals.

He offers the following tips for people who want to incorporate "chartistry" into their investing decisions:

1. Start with a fundamental look at the company based on its earnings and dividend potential. "Don't start by looking at charts," Littlejohn says.

2. Use the same metrics consistently. The process of charting stocks aims to provide consistent benchmarks and measurements that remove emotion and replace it with specific buy and sell targets.

3. Watch moving averages. This is the basic concept of charting. When a stock moves out of its trading range, it suggests movement, up or down.

4. Question your emotions. "Most of the time when you base a decision on emotions, you will be wrong," Littlejohn says.

[See: 13 Lucky Events That Call for a Financial Plan.]

He reaffirms the first point: Don't get carried away with charts. "Before you even start doing that, evaluate the fundamentals because they are what supports everything. Otherwise, you are just running with the lemmings," he says.

Technical analyst Roth puts less stock in those fundamentals, and still argues that emotions will always trump "information-based" decisions. After working for nearly 50 years on Wall Street at firms such as Morgan Stanley and Miller Tabak, Roth has dealt with his share of skeptics. Now in retirement, but still an active market-watcher, he feels vindicated by the work of behavioral scientists. "It's a huge confirmation from academia when they say there is information in those chart patterns," he says. "We've known it for 100 years. We called it market psychology. Now it's behavioral finance."

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