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Does an Efficient Market Render Technical Analysis Ineffective?

Original post by Adam Parker of Demand Media

The efficient market is a concept that concerns the nature of market prices and the level of returns that investors can hope to achieve. This model opposes the concept of technical analysis because each system rests on different assumptions. While the efficient market theoretically contradicts attempts at technical analysis, there is some dispute concerning the correspondence between theory and reality.

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Efficient Market Hypothesis

The efficient market hypothesis (EMH) is a theory stating that the market is always efficient. Put another way, EMH maintains that it is impossible to consistently beat the market because prices always reflect all available information. This theory is controversial in the financial world.

EMH & Technical Analysis

Technical analysis is the broad area of market analysis concerned with predicting future trends based on past prices. As such, it is based on the theory that investors can obtain information regarding future price movements in excess of the information allowed under EMH. This is due to the fact that technical analysis places significance on past prices, while EMH does not. In particular, technical analysis relies on identifying trends while EMH does not acknowledge the existence of market trends.

Support for Technical Analysis

Going beyond the basic concepts underlying technical analysis, some suggest that it may be effective due to self-fulfilling prophecy. In other words, if enough investors use and rely on technical analysis, that in turn causes technical analysis to be an effective technique. This observation ties into other general critiques of the efficient market hypothesis. Essentially, opponents argue that investor expectations and biases factor into market prices in ways that EMH does not acknowledge.

Significance

The significance of the conflict between the theories of technical analysis and the efficient market hypothesis is that both cannot be valid, at least not totally. Assuming that the theoretical efficient market exists in reality, it does render technical analysis ineffective. On the other hand, any evidence for the effectiveness of technical analysis is evidence against the validity of the efficient market hypothesis. If one views EMH as a general rule of thumb rather than an absolute law of market activity, this leaves open the possibility of technical analysis being effective in certain market conditions.


                   

References

About the Author

Adam Parker is a writer from Virginia. He holds a Bachelor of Science from James Madison University. Parker has written articles for online sources including The Motley Fool, Gameworld Network and Glossy News.


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