By: Investor Solutions, Inc.
Let me start by saying that the purpose of this article is not to support or refute the predictive value of technical analysis. Some have succeeded with this method, most haven’t. Instead my intention here is to stress on the impracticality of this method. So that the next you come across an infomercial on a Sunday morning about a new technical analysis software and wonder if it is all worth it, you will flip the channel and move on to better things.
A Quick Overview
Technical analysis is the study of price movement, primarily with the use of charts. A good way to summarize this methodology is by borrowing the following analogy from “In a shopping mall, a technical analyst will sit on a bench and watch people go into the stores. Disregarding the value of the products in the store, his or her decision to buy a product or not will be based on the patterns or activity of people going into each store”.
This methodology is driven by the following three premises:
All information is reflected in price.
A technical analyst is not concerned with company fundamentals and economic factors as these components are already considered in the price of the security. A chartist will only focus on past trading data (i.e. price and volume) in an effort to identify future price patterns.
Analyzing stock charts is also supported by the supposition that stock prices tend to follow in trends. For example, in an uptrend a stock price that is generally moving higher. In downtrends the opposite occurs. Once a trend is in full swing the likelihood of the future prices to go against it is small.
And finally, chartists believe that history repeats itself. This characteristic stems from the fact that investor reaction to market movement tends to be consistent over time.
So far, the methodology looks attractive. Price movements are repetitive and they follow trends. So the road to riches is finding those trends in price charts and acting on those findings. Simple! Or is it?
For the most part, the practice of chart analysis is time-consuming. A chartist spends countless hours staring at graphs looking for indications on what a security or market will do in the future. For a professional analyst, I do not doubt it is fascinating. For a common investor with a day job and very little time to spend on chart analysis, it can become quick frustrating. And quitting your job to become to become a full-time chartist is certainly not recommended.
The frustration experienced by most practitioners stems from the fact that trading strategies are not always meticulously defined. Technical analysis is an art not a science. For the most part, the decision to act on a particular chart formation, indicator or oscillator is left to the discretion of the practitioner.
For example, you are a chartist and have identified what appears to be a head-and-shoulder formation. Or could it be the beginning of another formation? How long do you wait until you trade? Until you are sure of what you are seeing? Will it be too late? I do not care about what those infomercials say; there is nothing exciting about waging money on blurry charts. It is stressful and frustrating.
My last point is the following: the more people practice technical analysis the less likely it is to work. If hundreds of thousands or even millions of people are looking for a chart formation for a particular stock, the chance of everyone getting in fast enough to enjoy the rise that it is supposed to predict is nil. Technical analysis does not guarantee results. Would you get on a treadmill for 45 minutes a day, three times a week if you were not guaranteed results?
Technical analysis is time-consuming, ambiguous and does not guarantee a good result. I cannot imagine why one would subject oneself to such an arduous process when there are clearly better alternatives, such as designing a properly diversified global portfolio designed with a long-term strategic outlook. Investing is a science. A proper savings plan and investment strategy will get you much farther (financially and emotionally!) than those get-rich-quick schemes advertised in infomercials.