Technical Analysis

What is technical analysis?

Technical analysis, also known as charting, is the process of looking at a stock or stock index price history to try and predict how the price will move in the future. We instinctively use this technique on a basic level when we look at stock charts. We think, the price will continue to go up if its gone up lately and go down if its gone down lately. Users of the technique go into much greater sophistication with fancy rules regarding graph shapes, trading volume, and other historical price numbers.

Why is using charting a poor decision?

• Despite what proponents tell us, there is no conclusive evidence that it actually works. Therefore, it is really just speculation and not investing.
• Different charters interpret the same patterns differently. They can't agree on what works because they're just making guesses. Again, this points to it being speculation.
• Our human desire to see patterns that are not there fools us into believing in technical analysis. For example, the face of man on Mars makes us think someone created it and that there used to be people there, but in reality, it is just something that coincidentally looks a lot like a face. Also, I remember soon after September 11th, people were seeing 911 everywhere and freaking out. This is not surprising considering its a 3 number combination that should show up frequently considering the countless number of numbers out there.
• They don't actually look at the companies behind the stock. To them, stocks are just tickers that create patterns. In reality, stocks are small pieces of ownership of a company and will grow or decline in the long-term based upon the actions and results of that company. "Price is what you pay. Value is what you get." ~ Charlie Munger
• It sounds scientific, but it isn't. They usually do "backtesting" to prove that their system works. I can come up with many silly systems that work historically, but really have no advantage. For example, lets say you go over the top pop songs charts and you gather the history of the first letter of the name of the artist at the top of the list for each week for 30 years. Then you crossed that data with the data of the weekly stock market performance based upon the starting letters. There are bound to be some letters that have much better or worse "performance" than others. Does this mean that you should invest in the future based upon the current top artist in the pop charts? Absolutely not. That would be absurd. This is a silly system that, when back tested, appears valid, but in reality is meaningless and useless.
• There's a fundamental misunderstanding of cause and effect going on here. For the most part, a stock doesn't go up or down because it has gone up or down recently. In the long run, it goes up or down based upon earnings growth or declines, dividends, and general industry news. In the short run, stocks can go in any direction regardless of the current news or past price history. The best investors in the world never claim to know to know the short term movements of stocks. JP Morgan said it best when asked what he thinks the stock market will do in the near term, "It will fluctuate."
• Charting generally pushes someone to short-term trading. This creates a bigger tax bill and more brokerage fees.

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