5 Main Assumptions Behind Using Technical Analysis

In our discussion of the three main styles of investment management, we have already covered macro investing. Now we turn to the second main approach, technical analysis.

Technical analysis is concerned with supply and demand in the marketplace. While other approaches attempt to develop ideas which lead to actions, technicians focus on actions that lead to further actions. By examining price history and volume data, technicians ignore what has caused an event and focus on the event itself. By studying stock charts, we emphasize the effect over the cause, eliminate confusion, and allow ourselves to predict the future path of prices.

I have long felt that too many investors focus on the cause over the effect. By building elaborate ideas about how markets should perform, investors become frustrated when the world does not behave as they predicted. Such frustration often leads to indecision. In rapidly evolving markets, we are better served to focus on the actions that occur and use this knowledge to position for the future. Technical analysis allows us to do just that.

Before embarking on a journey to technical trading, we are best served to understand the five main assumptions of this approach. These are:

  1. Art over science – Many investment approaches require us to perform a great deal of math to generate an answer. Technical analysis does not. Looking at the same chart, many investors will derive different answers. Therefore, reading charts evolves into an art form where each analyst can provide a unique insight.
  2. No need to know – As more information becomes available, people become obsessed with knowing why events occur. In the markets, we often never know. Instead of searching for the next piece of data that magically unlocks the puzzles, technicians focus on the past and interpolate how it will affect the future.
  3. History repeats – A study of history shows that set patterns repeat themselves over long periods. By relying on the past to predict the future, we can take advantage of these patterns.
  4. Self-fulfilling prophecyEnough people seeing the same pattern will take actions that force the prediction to occur. While this is positive if you are on the right side of the trade, it presents a major weakness when everyone attempts to exit at the same time.
  5. Momentum reverses – When a trade becomes very crowded with everyone assuming the same position, unexpected surprises can drive prices. If the exit becomes crowded, what first looked promising quickly becomes a nightmare.

In many markets, technical analysis serves as a solid series of guiding posts. By examining trends, we increase the likelihood that markets remain in our favor and trades remain profitable.

Sean Hannon, CFA, CFP is a professional fund manager.

Further Education, Technical Analysis: