Investing is risky business these days. No one is quite sure what to make of the Dow, the S&P500, or the NASDAQ. Forget about European markets. Most people in America are struggling to figure out whether Obamacare will destroy jobs, wreak havoc in the marketplace, and kill their retirement plan. Well, you don’t have to wait for some stupid politician to muck things up. All you have to do is follow the very popular technical analysis investment strategy.
The field of technical analysis creates stock prices based on something they call "market psychology" and historical returns. Stock prices, according to the theory, cannot have anything to do with reality and are basically created out of the thoughts, feelings, and whims of investors.
1. The Market Discounts Everything
Technical analysis assumes that investors (and the market) are inherently irrational. It also believes that all relevant information about a stock is reflected in the price of the stock. This makes the financial markets incredibly efficient. This only leaves the analysis of price movement. Technical analysts believe that the supply and demand for a particular stock in the market forms the basis of good investing ("the good" as applied to investing).
2. Price Moves in Trends
The technical analyst believes that stock prices move in or follow various trends. This means that after a trend has been established in the financial markets, the future price of that stock is more likely to continue moving in the same direction that it has been moving and is less likely to break the trend and move in the opposite direction.
3. History Tends To Repeat Itself
A very important idea in technical analysis is that history tends to repeat itself, and that stock price movements can largely be determined by historical movements (called "trends" or "patterns"). The repetitive nature of the stock market is explained by something technical analysts call "market psychology". Their explanation is that investors tend to provide a consistent reaction to similar market stimuli over time. Technical analysts use charts that contain a vast amount of historical market data to attempt to predict future price movements. While many of these charts have been used for over 100 years, they are still thought to be valid because technical analysis believes that historical returns can be used to predict future price movements in the stock market.
As investors, all we need to do is find the “right” pattern and trade on that pattern. The underlying premise, which is often unspoken, is that the returns in financial markets are already there, and will be there in the future (hence the idea that we can trade on a specific pattern or patterns). All we need to do is capitalize on them.
The Problem With Technical Analysis
Every form of traditional technical analysis that uses data mining and historical returns to predict future price movements ignore cause and effect. No business, no company, exists in a vacuum or arbitrarily, and neither does the pricing of its stock.
Technical analysts believe that each individual investor somehow comes up with their own price. How do they do this? No answer is ever given. Whatever investors think the price of the stock should be is the "right" price – is what the stock is worth. This is what makes technical analysis subjective. Stock prices become an arbitrary creation of investor’s minds. Whatever they want the price to be is what it is, and the most consistent practitioners of technical analysis will readily admit this.
How the heck do you invest on this premise? In theory you are supposed to find a "good looking" stock, buy it, and then hold that stock until it returns the kind of profits that you want. In practice, you are just buying what everyone else is buying. It’s more or less like a dog chasing his own tail. How do you make money? Simple. By buying what everyone else is buying you follow (and become part of) a trend. If the trend is up, you make money, if the trend is down, you lose money.
In actuality, you are doing little more than guessing. You might make money, or you might lose money, but you are basically tossing a coin and hoping for the best. If enough people get together to buy the same stock and they are all guessing the same thing, does this make their pick "valid" or "right"? No, it does not. 50 million Frenchmen can be wrong. Reality is not subjective, and neither is investing. It doesn’t matter how many people buy into a particular stock. The subjective feelings of 2 investors or 2 million investors does not determine the price of a stock.
This kind of technical analysis encourages investors to trade on fictitious long-term patterns. But no such long-term patterns exist because historical returns are not predictive of future returns. If technical analysis could be followed consistently, there would be no risk in financial markets and thus no risk in investing.
But, what about technical analysts that seem to make a lot of money? The only valid form of technical analysis relies on observing phenomena in the financial markets but does not base its trading on long-term historical results or data mining.
Discovering that many individuals get paid on Friday, for example, a savvy technical analyst may pick up on a very short term pattern developing. This is more or less a behavioral phenomenon. The rational explanation for this is simple: people get paid at the end of the week and buy into the stock market through weekly contributions. This happens via 401K plans or through direct stock or bond purchases.
A savvy trader picks up on this idea because he notices that all of this buying causes a temporary rise in stock prices at the end of the week. The trader sees this, and then exploits it by selling off his positions or finding short-selling opportunities to correct the temporary distortion in the financial markets. By doing this, the phenomenon disappears which prevents any true patterns from ever forming. The reason for eliminating patterns is simple: the profit motive. Traders make an incredible amount of money by finding and exploiting phenomenon before they ever become true patterns. When the phenomenon disappears, the monetary incentive to short-sell or sell off positions also disappears.
Some alleged patterns are just a matter of clever data mining and reconstruction. The human mind can create order out of what seems to be random data. Think about how an individual will often see images in clouds, the "man in the moon", or any number of other creative illusions formed from subjective thinking.
With enough data mining and enough graphs, a "story" can be created out of the statistical data to make practically everything sound legitimate. All of this is an attempt to make sense of what is, in actuality, just a random set of circumstances, facts, and numbers.
This technical analysis – the "story" – can then be passed on to the lay person as a legitimate reason to buy a particular stock or mutual fund. When you try to apply this idea in real life, you are left with a completely nonsensical, and arbitrary, method of investing and trading. This “method” of trading gives you absolutely no answers, only questions which cannot be answered because they are unanswerable. Not because you are not intelligent enough to understand the reasoning behind it, but because there is no reasoning behind it. This is why even professional traders do not consistently make money over the long-term with technical analysis.
Also make sure to read: