Technical analysis is a financial concept used by many investors for many different reasons. It’s a somewhat controversial school of thought, but technical analysis certainly has its proponents. That’s why we think a well-rounded investing education requires an understanding of this complex and sometimes divisive practice.
So what is technical analysis, and how might you use it as part of your investing strategy?
An introduction to technical analysis
Technical analysis was founded by one of the most famous names in stock market history: Charles Dow. He ‘invented’ the first market index, the Dow Jones Industrial Average, and with it the concept of technical analysis.
Dow first likened the movements of the share market to the ocean. Long-term bull and bear markets were ‘tides’ and the shorter-term movements were ‘waves’. With input from some other theorists, technical analysis was born from these ideas.
Technical analysis refers to the use of statistical trends gathered from trading activity to determine possible investing or trading opportunities. Technical analysts will look at share price charts and graphs to find patterns that indicate certain trends. It’s sometimes referred to as ‘charting’ for this reason.
Technical analysis uses data from the past to predict share price movements. Thus, almost any share can be used for technical analysis – all that is needed is a track record of trading on a stock exchange.
Unlike its rival school of fundamental analysis, technical analysis focuses more on pricing and trade volumes and eschews the underlying business fundamentals of a share to determine whether an investment should or shouldn’t occur. A technical analyst will be far more concerned with a share’s momentum or volatility than earnings growth rates or profitability, for example.
Key assumptions of technical analysis
The field of technical analysis relies on three key assumptions that support the theory’s validity.
The first is an inherent acceptance of the ‘efficient market’ hypothesis. This represents the idea that the market is almost always 100% efficient in its pricing mechanisms, incorporating every piece of publicly available and relevant information into a company’s share price at all times.
It’s because of this belief in the market’s efficiency that a technical analyst doesn’t support the theory that analysing a share’s fundamentals can produce a ‘market-beating’ outcome. Therefore, it is believed technical analysis is far more useful in determining both a share price’s short and long-term future. Or so the theory goes.
The second assumption is that the vast majority of all share price movements occur within a trend, even the movements that appear erratic or volatile. This trend might be a short-term or long-term one, but a technical analyst will always assume that a share price’s movements can be explained by looking at the past. In this way, a technical analyst can use these trends to build a strategy.
The third assumption is that a share’s past trends tend to repeat themselves, often in a cyclical manner. For example, trends following buying and selling pressure are often very similar over periods of time.
A typical pricing pattern that a technical analyst might observe is as follows: a share price may move away from and back to a long-term average in a wave pattern. It may spend a month rising above a pricing average (such as a 90-day moving average) and a week falling back to this support level, over and over again. As such, the analyst can predict when a good time to buy or sell will be based on these kinds of patterns or trends.
When should investors use technical analysis?
Technical analysis is a controversial school of thought and many investors go their whole lives without using it once, often with great results.
Here at the Fool, we don’t use technical analysis because we don’t subscribe to the notion that markets are always efficient, which is one of the central tenets of a technical analyst. Instead, we Foolishly invest using a company’s fundamentals and business strength, rather than what a chart tells us.
But that’s just us. There are unquestionably useful components of technical analysis, but many critics decry this discipline as simply a result of the ‘self-fulfilling prophecy’ effect. If enough investors believe in and practise technical analysis, then the pricing movements that the discipline highlights will indeed become indicative of some future moves.
Even so, many investors do use charting and technical analysis, often in combination with fundamental investing techniques.
Technical analysis can be useful in predicting a share’s short-term pricing moves if you’ve already decided on a ‘buy price’ using fundamental analysis, for example. In the world of investing, there is never a ‘right’ or ‘wrong’ way to invest, as long as it works for you and gets you results.