Skewness Preference and the Popularity of Technical Analysis
73 Pages Posted: 16 Nov 2013 Last revised: 8 Dec 2019
Date Written: February 24, 2016
The popularity of technical analysis is puzzling. We propose a simple model of how investors evaluate a trading rule, and show that the market timing of technical trading rules induces lottery-like trading profits. Therefore, investors' preference for positive skewness caters to the popularity of technical analysis. Since prospect theory implies strong skewness preference, it can explain why investors trade extensively on chart patterns that are meaningless in light of the efficient market hypothesis. Advocates of technical analysis often invoke behavioral finance as its theoretical foundation. Contrary to this view, our paper shows that ideas from behavioral finance can explain why technical analysis is popular despite its lack of theoretical foundation and empirical success.
Keywords: Behavioral Finance, Market Timing, Moving Average, Prospect Theory, Skewness Preference, Technical Analysis
JEL Classification: G02, G11, D03, D14
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