Is technical analysis an intellectually sound investment strategy or financial astrology?
In the financial markets, technical analysis (also called ‘chartism’) is a way of attempting to forecast the future prices of whatever security or investment instrument is under scrutiny (including forex) by focusing on its past price fluctuations.
Technical analysts seek to investigate patterns and trends in prices by developing mathematically-based indicators (there are hundreds of these) that are supposed to help predict price trends or levels of momentum, and even to suggest the ideal points in the fluctuation of a price when one should buy or sell.
On the face of it, technical analysis is little more than a form of financial astrology. Certainly, technical analysis is very different from fundamental analysis, which looks at real-life data relating to the actual financial instrument itself – such as the trading success of a corporation whose shares are being traded on a market – and quantitative analysis, which seeks to quantify an estimated return and the risk of obtaining that return, both for individual financial instruments and entire portfolios.
Yet, the truth is that, in practice, technical analysis is not really much more astrological than fundamental analysis and quantitative analysis. After all, the latter two also aim to try to predict the future.
Certainly, the highly-respected Efficient Markets Hypothesis (EMH) holds that when markets are efficient – meaning that all market participants have access to the same information – the prices of all financial instruments traded on the market in question will reflect all that available information.
The EMH implies that even if one particular investor might occasionally get lucky and produce better-than-average results, no investor is likely to produce consistently better-than-average results.
In practice, when investors do have runs of exceptional performance, it may be because they have found legal ways of getting access to information which not every market participant has. This, of course, is one reason why World Finance takes such pains and expends so much effort to bring its readers detailed information about trading and investment conditions around the world.
But no matter how detailed and exclusive one’s information is, the future remains impossible to predict. In practice, there is perhaps no inherent reason why technical analysis should be any less effective than fundamental analysis or quantitative analysis.
A deep insight into why technical analysis can be useful was provided by professional investor Tony Plummer when he was director of Hambros Fund Management in London. As explained: “With more and more people trading markets with a view to making short-term capital gains, the very nature of financial markets is changing. Financial markets were originally set up to support the ‘real’ economy: that is, the day-to-day real world of commerce in which companies which issue securities operate. However, once speculative activity starts to move beyond a certain critical mass, two major developments begin to take place. Firstly, financial markets start to behave independently of the physical world of production and exchange. Secondly, financial markets start to become more aligned with the emotional world of greed and fear.”
In other words, we shouldn’t be surprised if looking at a market and its price fluctuations purely as a market and as price fluctuations is a reasonable way to analyse markets, nor should we be surprised at needing to factor in the group psychology of investors – including their fears and emotions – in our predictions of how markets behave.
UK-based private investor Annelisa Lynch finds technical analysis an important decision support tool for managing her own stock portfolio.
“I firmly believe there are ‘trigger’ levels in charts and that, for example, there are many investors who will act depending on whether the share price retraces or goes through the trigger line. If it retraces than a big sell is likely to happen. On the other hand, if it goes through the line then people expect further gains and are likely to buy. Because so many investors are doing this it’s likely to be self-fulfilling.’
Whatever the precise truth of why technical analysis appears to work, what’s indisputable is that, worldwide, millions of investors take it very seriously and rely on it. If technical analysis really is just a form of financial astrology, it is certainly behind the success of many investment stars.