In the last few weeks we’ve been exploring different investment strategies such as value investing and growth investing.
These are all the various ways that investors make investment decisions.
This week we're exploring technical analysis.
This is the style of investing favoured by share traders, forex traders and Wall Street and something Warren Buffet has openly questioned the validity of it.
Personally I find this style of investing tedious and yet the irony is I spent all my time at university learning all about it – this is essentially what we’re taught in finance.
It involves numbers and spread sheets and can get quite complex.
what is technical analysis?
When we discussed value investing we spoke about how investors that employ this strategy buy under-priced stocks (shares) and hold onto them for the long term.
Growth investors look for a growing industry and stocks that are going to go up in price because the industry's growing.
The above investors assume the market is flawed and that company's share price doesn’t reflect the true value of the company.
They assume that as time goes by, more information about the company will become available and this information will start to impact the company’s share price.
Investors that employ technical analysis look for trends – they’re looking to see if the share price is on an upward or downward trend.
These investors assume the market is a good judge of company value and the share price reflects this – they’re concerned with what investors on the market will do with their shares – will they buy or sell?
The belief that human behaviour is predictable
Technical analysis is very different to growth and value investing because it doesn’t put a lot of store in financial statements (balance sheets, income statements, cashflow), board of directors, company ethics, etc.
Since they believe human behaviour is predictable, they also believe history repeats itself and if this is true there must be a trend in the way share prices move in the short, medium and long term.
Investors graph historical share prices to find trends.
One such trend is The January Effect.
Thanks to Technical analysis we now know that stock prices increase during the month of January.
There are many theories as to why this happens and they're fascinating but we’ll discuss this another time.
Pros of technical analysis
i. It’s less time consuming than growth and value investing
The reason why so many Forex and share traders use this investment strategy is because many companies have already done the research and that research is easily available online.
If you Google the historical share price of any stock exchange listed company, you can easily find the graphs and spreadsheets on Yahoo Finance or blogs.
This is easier than spending hours looking at financial statements and researching board members or managers and trying to understand their ethics or values.
ii. Great way for short term investors to make decisions
Looking at historical prices is a tool that allows us to make decisions on something either than our gut instinct.
Most traders are looking to make a profit in the short term so time is an important factor, and they don’t have time to do all the heavy research that growth investing and value investing requires.
iii. People understand the visual effects of graphs
Numbers and things like financial statements scare people because most people don’t know what they mean.
Seeing graphs (a visual image) of historical share prices makes investing easier for people.
I also look at when I decide which ETFs (exchange traded funds) to invest in.
Cons of Technical Analysis
i. Human behaviour isn't a great thing to rely on
Technical analysis works on the theory that human behaviour is predictable, which implies that humans are rational.
Human behaviour isn’t rational; it’s driven by emotions, especially where money or investments are concerned.
These emotions are driven by world events and the more intense the events, the more unpredictable the behaviour
ii. Share prices are determined by many different factors
A company’s share price is determined by so much more than just investors.
A huge part of what determines share prices is company profitability and profits rely on human resources or employees (including managers) in the company.
iii. It’s not a great tool for long term investors
If you plan to invest in a company for the long term, you can’t look at the past to help you predict the future.
At some point you’ll need to do the heavy duty research that value investors and growth investors do.
iv. Industry trends and intangible trends are not considered
Companies operate within an industry – you can’t rely only on pricing.
Take the oil industry – if you were using technical analysis 8 years ago, you’d have missed the rise of renewable energies and the new consumer trend to go green, which are now having a huge impact on the oil industry. These trends are partly driven by human emotion, namely empathy towards the planet.
As investors, we have to start thinking beyond pricing trends and develop a holistic view of the world.
We need to take into account human emotion and how these emotions can kill or birth industries and companies.
Let me know your thoughts in the comments section below!