I am extremely concerned about the volatility that we have seen recently in the stockmarkets. I have heard a lot about people who use charts or technical analysis to predict likely trends. How do these charts work and is there is any substance to them?
Technical analysis is a complicated sounding name for a basic approach to investing. Simply put, technical analysis is the study of prices, with charts being the primary tool.
The roots of modern technical analysis stem from the Dow theory, developed around 1900 by Charles Dow. These include such principles as the trending nature of prices, changes in price and support/resistance.
The Dow Jones Industrial Average is a direct offspring of the Dow theory.
The price of a security represents a consensus. It is the price at which one person agrees to buy and another agrees to sell. The price at which an investor is willing to buy or sell depends primarily on his expectations. If he expects a security's price to rise, he will buy it. If he expects the price to fall, he will sell it.
These simple statements are the cause of a major challenge in forecasting security prices because they refer to human expectations. As we all know, humans are not easily quantifiable nor predictable. This fact alone will keep any mechanical trading system from working consistently.
Because humans are involved, I am sure that many of the world's investment decisions are based on irrelevant criteria. Our relationships with our family, neighbours and employers and our previous successes and failures all influence our confidence, expectations and decisions.
Share prices are determined by money managers, students, doctors, lawyers and landscapers, the wealthy and the not so wealthy. The breadth of market participants guarantees an element of unpredictability and excitement.
If we were all totally logical and could separate our emotions from our investment decisions, then fundamental analysis (the determination of price based on future earnings) would work magnificently. Since we would all have the same completely logical expectations, prices would only change when quarterly reports or relevant news were released. Investors would seek overlooked fundamental data in an effort to find undervalued securities.
The hotly debated efficient market theory states that security prices represent everything that is known about the security at a given moment. This theory concludes that it is impossible to forecast prices, since prices already reflect everything that is currently known about the security.
If prices are based on investor expectations, then knowing what a security should sell for (fundamental analysis) becomes less important than knowing what other investors expect it to sell for. That is not to say that knowing what a security should sell for is not important – it is – but there is usually a fairly strong consensus of a stock's future earnings that the average investor cannot disprove.
Technical analysis is the process of analysing a security's historical prices in an effort to determine probable future prices. This is done by comparing current price action (current expectations) with comparable historical price action to predict a reasonable outcome. The devout technician might define this process as the fact that history repeats itself while others would say that we should learn from the past.
In my experience, only a minority of technicians can consistently and accurately determine future prices. However, even if you are unable to forecast prices accurately, technical analysis can be used to reduce your risks consistently and improve your profits.
The best analogy I can find on how technical analysis can improve your investing is a roulette wheel. I use this analogy with reservation as gamblers have very little control compared with investors (although, considering the actions of many investors over the last few years, gambling may be a very appropriate analogy).
A casino makes money on a roulette wheel, not by knowing what number will come up next but by slightly improving its odds with the addition of a 0 and 00.
Similarly, when an investor purchases a security, he does not know that its price will rise. But if he buys a stock when it is in a rising trend after a minor sell-off and when interest rates are falling, he will have improved his odds of making a profit. That is not gambling – it is intelligence. Yet many investors buy securities without attempting to control the odds.
Contrary to popular belief, you do not need to know what a security's price will be in the future to make money. Your goal should simply be to improve the odds of making profitable trades.
Even if your analysis is as simple as determining the long, intermediate and short-term trends of the security, you will have gained an edge that you would not have without technical analysis.