- Technical analysis is a bit of a misnomer since it is really not that technical. A better name for the use of charts to make investment decisions might be risk/reward analysis or even market psychology. Sure, there are some complex mathematical concepts involved with some of its more esoteric indicators. But at its core, technical analysis is simply a method of determining if a stock or the market as a whole is worth buying or selling. Once we identify this we are way ahead of the game with regard to assembling a winning portfolio.
- Simply stated, technical analysis is the study of data generated from the market and from the actions of people in the market. Such data includes price levels that have served as turning points in the past, the amounts of stock being bought and sold each day (volume), and the rate of change of price movements (momentum) over a given span of time.
- Technical analysis also attempts to measure the collective investor psyche, calling heavily on the psychology of crowds and the cycle of greed and fear. If everyone thinks one way, the odds that the market thinks the other are usually high.
- By contrast, the inputs of technical analysis–the price of shares and the volume being sold–never change after the fact. Charts are never revised later. Critics will point out that forecasting future price movement based on past price movement is akin to reading tea leaves or divining the future from the textures of chicken entrails. Many of the high priests of fundamental analysis are quick to call technical analysis the financial world’s alchemy. Indeed, chart watchers cannot predict the future any better than your broker, your spouse or a Ouija board. But what they can do better than most is make a decision about what to do–buy, sell or hold–based on the probabilities of the actions of others given certain conditions. In other words, if a pattern on the chart appears, a chart watcher can create a framework for what the market might do if and when prices break free from that pattern. It does not work every time, but past performance does give us an idea of what will happen so we can do something about it.
- Something chart watchers keep pasted to their computer screens is a sticky note that says. “All big losses begin as small losses.” When the initial reason for buying is gone, we do not hang around hoping the stock will go back up. Hope is a four-letter word in the world of investing.