Technical analysis involves the examination of past market data such as prices and the volume of trading, which leads to an estimate of future price trends and, therefore, an investment decision.
The philosophy behind technical analysis is in sharp contrast to the fundamental analysis that most investors use in stock selection. Fundamental analysis involves making investment decisions based on the examination of the economy, industry, and company variables that lead to an estimation of an intrinsic value of a share. Let us discuss below, how technical analysis works and helps investors in stock selection.
How does it work?
Technical analysis involves the examination of past market data such as prices and the volume of trading, which leads to an estimate of future price trends and, therefore, an investment decision. Technical analysts believe that using data from the market itself is a good idea because ‘the market is its own best predictor’. Technical analysts see no need to study the multitude of economic, industry and company variables to arrive at an estimate of future value because they believe that past price movements will signal future price movements.
Philosophy behind technical analysis
The market value of any good or service is determined purely by the interaction of supply and demand. But supply and demand are governed by numerous rational and irrational factors. These factors include economic variables as used in the fundamental analysis as well as opinions, moods, and guesses. The market weighs all these factors continually and price changes accordingly. Generally, prices for individual shares and the market tend to move in trends, which persist for appreciable lengths of time. The prevailing trends change in reaction to shifts in supply and demand relationships. These shifts, no matter why they occur, can be detected sooner or later in the action of the market itself.
Advantages of technical analysis
Technical analysis as a field of study has many advantages compared to fundamental analysis. Fundamental analysts can experience superior returns only if they obtain new information before other investors and process it correctly and quickly. Vast majority of investors do not consistently get new information before other investors and process it correctly and quickly.
Another major advantage of technical analysis is that it is not heavily dependent on financial accounting statements which are the major source of information about the past performance of a firm or industry. Followers of fundamental analysis use such statements to project future return and risk characteristics for industries and individual securities.
Challenges to technical analysis
This field of study is not free from criticism and has its own challenges. Unlike fundamental analysis this domain is not based on a strong foundation of theories (barring very few) and supporting empirical tests. Another challenge is that the past price patterns or relationships between specific market variables and share prices may not be repeated. So, a technique that previously worked might miss subsequent market turns. Two technical analysts looking at the same price pattern/chart may arrive at widely different interpretations of what has happened and, therefore, will come to different investment decisions.
To conclude, technical analysis is an alternative method of making the investment decision. Therefore, as an investor whether you are a follower of fundamental analysis or an advocate of technical analysis, you should still have an understanding of the basic philosophy and reasoning behind technical approaches.
The writer is a professor of finance & accounting, IIM Tiruchirappalli
LESSONS FROM PAST
Technical analysts believe past price movements will signal future price movements.
It is not heavily dependent on financial accounting statements.
Unlike fundamental analysis this domain is not based on a strong foundation of theories and supporting empirical tests.