A lot of investors believe technical analysis is hogwash. They say you can’t just look at a chart and predict future price movements. That is true to some extent, but it’s also a vast generalization. There’s an entire group of brilliant investors who are known as technical analysts who often get bunched into this “mindless” charting crowd when in fact there is much more to their investment strategies than drawing lines on a chart. Wikipedia defines technical analysis as:
“a security analysis technique that claims the ability to forecast the future direction of prices through the study of past market data, primarily price and volume. In its purest form, technical analysis considers only the actual price and volume behavior of the market or instrument. Technical analysts, sometimes called “chartists”, may employ models and trading rules based on price and volume transformations, such as the relative strength index, moving averages, regressions, inter-market and intra-market price correlations, cycles or, classically, through recognition of chart patterns.”
A distinction should be made here. Chartists are always technical analysts, but technical analysts are not always chartists. For instance, trend followers often write complex algorithms, computer models or trading models/rules that are based almost entirely on past price action without ever glancing at a chart. Some of the biggest and most successful hedge funds in the world are technical analysts, but not chartists. The Wikipedia definition goes on:
Technical analysis stands in distinction to fundamental analysis. Technical analysis “ignores” the actual nature of the company, market, currency or commodity and is based solely on “the charts,” that is to say price and volume information, whereas fundamental analysis does look at the actual facts of the company, market, currency or commodity. For example, any large brokerage, trading group, or financial institution will typically have both a technical analysis and fundamental analysis team.
This again is misleading because you can be a technician without using charts. Also, this is a personal belief, but I don’t view technical analysis and fundamental analysis as being all that different. When you look at a chart or past data you are essentially looking at the past performance of an asset’s underlying fundamental performance. For instance, Microsoft stock didn’t go up in a straight line during the 80’s and 90’s because the chart was going up. The chart went up because Microsoft was consistently growing their revenues and EPS. In essence, when you see a “good chart” you are viewing the market’s current and past fundamental perspective of that asset.
The harshest critics of technical analysis tend to be fundamental analysts. You know, the same people who run discounted cash flow models all day using PAST data to predict future prices. Then they apply some guesses about future interest rates and potential economic conditions (none of which they can accurately predict) and they believe they have applied some sort of intelligent math based solution to the investment world. They haven’t.
I agree to some extent with fundamental analysts. As Buffett said:– I believe it’s silly to glance at a chart and believe that you can predict the future price of an asset without also looking at a balance sheet or the surrounding economic conditions. I think most people love charts because they are easy to understand unlike a balance sheet. That doesn’t make them more useful though. Rather, the two compliment each other.
It’s easy to criticize anyone who boxes themself into a corner. For much the same reason that I don’t only trade one asset class I similarly don’t only use one method to invest. For instance, I am not a buy and hold investor, but I probably learned more from reading Warren Buffett’s annual letters than I have from any other single investment source. But I have probably spared myself countless dollars by using technical analysis to implement buy and sell points. What am I getting at you ask? Be flexible. Don’t be critical of someone else’s strategy because in all likelihood you’re using elements of that same strategy in your own. Likewise, you might just find elements of that strategy useful at some point during this ever changing investment environment.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.