Technical analysis is a hot topic in investment circles. Everyone from internet forum participants to billion dollar hedge fund managers seem to have a strong opinion about its value. The advent of online investing with its free access to trading platforms offering every type of technical indicator and chart type has made technical analysis the default analysis tool for the average investor. However, many investors do not understand how to properly utilize or even view technical analysis as an investing tool.
1. Art Not A Science
Since the start of the financial markets, investors have tried, mostly in vain, to quantify technical analysis and turn it into a science. Price charts are open to interpretation by the observer. One technical analyst will think a particular pattern is bullish, while another will see it as bearish. The old saying, "If you ask three technical analysis what the price chart is revealing, you will get four different replies," is very accurate!
The reason TA cannot be a science is the fact that if repeatable patterns actually existed in the market, the designs would be exploited to the point of no longer offering an edge. There are thousands of mathematicians and finance PhDs working for massive funds who search for patterns with sophisticated computer software far out of reach to the average investor. Once even the inkling of a pattern emerges, the funds race to exploit it, rendering it quickly obsolete then its on to the next one. Think of it as an arms race of sorts leading to short term price pattern destruction.
Now, as an interpretive art, some short-term investors appear to be able to use technical analysis effectively via experience and intuition. However, be aware, that the evidence is often anecdotal lacking objective rigor.
2. Subjective Not Objective
Despite many efforts to make technical analysis objective, it remains a subjective endeavor. What I a mean is that charts are open to interpretation and not objective. You may be familiar with software like Wizetrade's red light/green light system. They advertised heavily on financial TV in the mid 2000s. It is an example of an attempt to make TA objective for retail investors. Needless to say, the system did not work as marketed!
3. Beware Of Hindsight Bias
One of the most devious problems with technical analysis is due to a flaw in human psychology called hindsight bias. We all battle with hindsight bias to differing degrees. The official definition of hindsight bias from "YourDictionary" is the tendency of people to overestimate their ability to have predicted an outcome that could not possibly have been predicted. In essence, the hindsight bias is sort of like saying "I knew it!" when an outcome (either expected or unexpected) occurs -- and the belief that one actually predicted it correctly.
Applied to invest, hindsight bias is the tendency to look at a price chart and think how easy it is to identify turning points. The reason this is dangerous is the chart only shows the past, not the future. However, your mind will fool you into thinking that because something repeats a few times on the chart, it will happen again after you enter the trade.
Falling prey to hindsight bias is a classic mistake of investors who use charts to make decisions. Be sure you are aware of hindsight bias when using technical analysis!
4. Indicators always lag price
Technical analysts have a toolbox of indicators to help make decisions. These indicators include moving averages, stochastics, Bollinger Bands, and a host of others. Many investors erroneously believe that indicators help predict the next move. Nothing can be further from the truth since indicators lag the actual price. Saying it another way, price moves before the sign rendering short-term trading via technical indicators an exercise in futility.
5. Don't Neglect It
Despite all its flaws, investors should not neglect technical analysis. There are several ways technical analysis can be used effectively in the financial markets.
First, I like to use TA as a method of screening stocks to locate potential investments. Looking for breakouts, 52-week highs and lows and abnormal price movements can alert you to stocks that may make profitable investments. However, always look behind the price movement to determine what is causing it before investing. In other words, make sure you know the fundamental reason(s) supporting the price move.
Secondly, the 200-day simple moving average has been shown to have some predictive ability over the long term. An upward sloping 200-day SMA is a strong tell that the stock will continue higher.
Thirdly, TA is descriptive, not predictive. Using it to describe price action is where it excels.
Finally, technical analysis is a great tool to place the market and individual stocks in context with each other. Using it to compare and contrast potential investments makes sense.
Risks To Consider: Hindsight and survivorship bias makes trading strictly from charts fraught with danger. Always consider multiple data points beyond price movement before making investment decisions.
Action To Take: Learn to think about technical analysis the right way. It can be a valuable tool when used in conjunction with other analysis methods.
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