Sunday, March 18, 2007

What do You Think of the Dow Theory? What do the Researchers Think?

For those who are into the Dow Theory version of technical analysis, Mark Hulbert at MarketWatch has a bit of a review, which I've linked to below, including the interesting note that the three Dow Theory newsletters do not agree on what it says about the present state of the market and the outlook. two are bullish, and the third is bearish. Now stop and think on that for a moment.

Hmmm. Academic researchers pretty much "busted" the Dow Theory decades and decades ago. Mark does refer to one Journal of Finance article all the way back in 1998 which argues for its validity. I don't know if anyone other than the authors was convinced! The Dow theory, like technical analysis generally, has pretty much been in the academic dumper for a generation now. When you test it, it consistently fails to succeed any more often than dart-throwing at the Wall Street Journal.

So, why do people cling to ideas after they are tried in the crucible of research and found to fail? Is it a matter of human nature? Of needing something on which to base decisions? Two things are definitely true. First, the folks who sell newsletters have a conflict of interest. They make a lot of money selling those newsletters. Second, Wall Street's brokerages like clients who trade a lot, be they big hedge funds or little guys investing on their own with newsletter in hand. They have a conflict also. Trading is money, commissions and/or spreads (discounts or premiums, technically,) on crossing transactions to them. Applying a technical analysis-based approach requires a lot of trading, generally. Being as gentle about this as possible, they are self-interested, and the consequences of conceding the failure of technical analysis would be somewhat difficult, particularly for the newsletter writers.

Also, what do you base investment decisions on, if this old, once-popular approach is not really any good? I have advocated in this blog a globally-diversified, multiple asset class approach, using indexed vehicles at least as the default choice. This approach has excellent research support. Well, you may ask, it this idea is so good, why isn't everybody doing it?

Mr. Roger Gibson wrote one of the most remarkable books on investing, primarily for financial advisors, Asset Allocation - Balancing Financial Risk. (3rd. ed., Mcgraw-Hill, 2000.) He writes of what he calls a "quadrant 4 worldview of investing", where the investor, after reviewing what is known about the realities of investing, concludes that neither market timing nor active security selection (stock-picking, for us,) will succeed over time in beating the market. The quadrant 4 worldview is in good accord with the consensus of a mountain of objective financial research. So he writes on the implications of a quadrant 4 view:

"First, a quadrant 4 worldview undercuts to a large degree the reason for the existence of the money management profession." It means that the billions and billions of dollars in fees and expenses investors pay to keep up the lifestyles of the cast of thousands employed in attempts to beat the market are largely wasted. Worse than wasted actually, as what you get for trying to beat the market these ways is that usually you do worse than the market, when all the costs are counted. So, who at your local wirehouse brokerage or online broker is going to tell you that!

They don't even typically talk about that to each other. What newsletter writer is going to want to face that, much less tell you?

The beauty of the "quadrant 4 worldview" is that it lets you, knowing the score, knowing the reality of risk, use market forces rather than fight them. it lets you invest in hope based on what is real! Market returns over time have been good enough to be really worth going after. And wouldn't you, when you think about it expect it to be that way when all is said and done?

What the Dow Theory has to say about current stock market - MarketWatch

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