How investors can gain from technical analysis

Written by P Saravanan | Updated: Apr 22 2014, 09:15am hrs
For any investor, its important to understand the difference between technical and fundamental analysis. Technical analysis involves the examination of past market data, such as prices and volume of trading, which leads to an estimate of future price trends and, therefore, an investment decision.

While fundamental analysts use economic data that are usually separate from the stock or bond market, technical analysts believe that using data from the market itself is a good idea because the market is its own best predictor. Therefore, technical analysis is an alternative method of making an investment decision and answering questions such as: What securities should an investor buy or sell When should these investments be made

Technical analysts believe that there is no need to study the multitude of economic, industry and company variables to arrive at an estimate of future value because past price movements will signal future price movements.

According to them, fundamental analysts can experience superior returns only if they obtain new information before other investors and process it correctly and quickly. Technical analysts do not believe that the vast majority of investors can consistently get new information before others and consistently process it correctly and quickly.

Benefits of technical analysis

The technique is not heavily dependent on financial accounting statements the major source of information about the past performance of a firm or industry. There are several problems with accounting statements:

(a) They lack a great deal of information related to sales, earnings and capital utilised by product line and customers;

(b) According to GAAP (generally accepted accounting principles), companies may choose several procedures for reporting expenses, assets or liabilities. These alternative procedures can produce different values for expenses, income, return on assets and return on equity. As a result, an investor can have trouble comparing the statements of two firms in the same industry, much less firms in different industries.

(c) Many psychological factors and other non-quantifiable variables do not appear in financial statements. Examples include employee training and loyalty, customer goodwill and general investor attitude toward an industry.

Fundamental analysis uses data such as share prices, volume of trading and other trading information derived from the stock market itself. Further, in fundamental analysis, new information is processed quickly to derive the new intrinsic value for the share or bond before the other investors can.

Essentially, technical analysis makes an attempt to understand the sensitivity and emotions in the market by studying the market itself, contrary to its components as in the case of fundamental analysis. As an investors, if you understand the advantages and challenges of technical analysis, it can provide a new set of perspective and tools that will help you to become a better investor.

The writer is an associate professor in finance & accounting at IIM Shillong