In my post entitled “Stock market investing schools of thought“ I introduced to you three major investing styles or “stock market investing school of thoughts” upon which all other investing strategy has been derived from. I gave the “advantages” and what the critics say about each style. Since I adhere to value investing, I have nothing to say against fundamental analysis.
This article is somehow a continuation of the investing school of thoughts article as I will discuss in detail here why technical analysis does not work. I am writing against technical analysis because majority of market players use this strategy. I’d probably be crucified by most stock market players by writing this article as there are lots of them who use technical analysis. Let me make my position clear, I have no qualms about people using a technical analysis together with fundamentals or whether they consult Madame Auring when the pick stocks for as long they give weight to the fundamentals of business of the stock they are trying to buy. What I am against is the use of pure technical analysis alone in making investments decisions.
Let me give you five reasons why using technical analysis in stock market investing does not work and why you should not rely on it to make investments decisions.
Reason #1 – Using technical analysis in stock market investing does not work because of its nature
The nature of Technical analysis is that it is based on market psychology which in turn is anchored on the individual sentiments of each individual investor. Each individual has unique thoughts about the stock he is buying making each individual investor take different courses of action. Investment bank State Street Global Markets describes this rightly when it described the market’s sentiment in the credit crunch of 2007 “Market participants don’t know whether to buy on the rumor and sell on the news, do the opposite, do both, or do nothing, depending on which way the wind is blowing . . . “
I find it very ironic that people say that the pattern that they are searching for using technical analysis eludes them. They reason out that perhaps they need to learn more about technical analysis, or follow this and that system or buy the latest book on the latest technically analysis system. What they don’t realize is that the pattern they seek is created by them! This is akin to a cat chasing his short tail, which he always fails to catch.
If each individual views stocks as investments and buys stocks from a business perspective, we will not have such wide gyrations in the market. True, that there will still be movements in the market much like there are price movements in any kind of market, but such movement will be much more stable. Just like in the fish, meat or poultry market wherein prices don’t move wildly everyday. There may be a difference in price, but it is much more stable. I have never experienced walking into a fish market and buying fish today worth P100.00 while the next day it sells for just P 30.00. Probably this will happen under unique circumstances such as when people do not want to buy fish because of a fish kill. But ordinarily this rarely happens in a fish market and if price changes do happens, the price movements and changes are small. In contrast, the stock market price movements are so erratic that in really big markets, the changes happens almost every second! There is no other market that is as moving wildly as the stock market.
Anchoring stock market investing decisions based on market psychology is very dangerous. It is akin to gambling. There is no pattern to speak of. You can never predict what the market will be thinking. It is all guesswork. You might as well consult Madame Auring rather than rely on technical analysis. When he lost a fortune because of investing in the South Sea Bubble, Isaac Newton lamented “I can calculate the movement of the stars, but not the madness of men.”
The father of value investing, Benjamin Graham once described market sentiment as embodied in an allegorical figure named “Mr. Market” who is portrayed as sort of “manic depressive.” In his classic book “The Intelligent Investor” he writes about Mr. Market and says “Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly . . . You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings…” ” (Emphasis added)
Watch out for the next post “Why using technical analysis in stock market investing does not work – Part 2“
By the way here is a funny youtube video on the stock market works. You might find yourself laughing at this, but this is how market sentiment works. (The first part talks about market sentiment, the second part talks about the U.S subprime mortgage problem)
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