Technical Analysis and Theory of Finance

Abstract

In this paper, we analyze the usefulness of technical analysis, specifically the widely used moving average trading rule, from an asset allocation perspective. We show that when stock returns are predictable, technical analysis adds value to commonly used allocation rules that invest fixed proportions of wealth in stocks. When there is uncertainty about predictability, the fixed allocation rules combined with technical analysis can outperform the prior-dependent optimal learning rule when the prior is not too informative. Moreover, the technical trading rules are robust to model specification, and they tend to substantially outperform the model-based optimal trading strategies when there is uncertainty about the model governing the stock price.

Keywords: Technical analysis, trading rules, asset allocation, predictability, learning

JEL Classification: G11, G12, G14, C11, C61