Understanding market irrationality and indicators of technical profitability

Abstract

The real world financial markets are known to have inefficiency driven by a number of cognitive limitations and emotional biases. Research has shown that human cognitive capabilities are significantly constrained in their functioning. What we perceive as reality is largely an illusion constructed by our brains1. Over the course of time, however, the human brain is capable of adapting to its environment and of producing relevant information through processes of learning, memory and attention2. Humans tend to create cognitive shortcuts in the process, but they are maladapted for financial world and often creates distortions in the market. For instance, investors and traders leverage a moving average timing strategy of technical analysis to portfolios sorted by volatility to generate investment timing portfolios that substantially outperform the buy-and-hold strategy3. The chartists employ a wide variety of technical rules based on the price history of an asset in an effort to minimize the cognitive effort involved in the valuation of financial assets.