5 Reasons You Can't Trust Technical Analysis

David Goodboy's picture

Wednesday, February 7, 2018 - 2:30pm

by David Goodboy

If you're like most modern-day stock market players, technical analysis likely plays at least a small part in your investment process. Even if you don't study the charts yourself, you probably read some analysis of "bullish" and "bearish" patterns on stocks you own or are thinking of buying.

All stock trading platforms and brokers provide some type of charting software. Some sites even allow you to place orders directly from the chart, making it extremely easy to buy or sell based on the price movement.

Things were not always this way. When I started investing, technical analysis was an arcane subject practiced by only the hardest of the hardcore market junkies. The practice was difficult without the help of a PC and real-time data feeds. In those days, investors would painstakingly plot daily prices by hand on graph paper or use charts provided by newspapers or financial publishers.

Making things even more impossible was the fact that charts were mostly based on the daily closing price. Investors were forced to plan their trades based on charts that very well may have been out of date by the time the order went through.

But today, instant availability, ease of use, and promotion by brokers has made technical analysis the default way to make decisions by today's investors. No one seems to question whether or not investing strictly from charts makes sense. It has become so widespread that it is simply accepted by the vast majority of investors.

I started out as a technical analyst. Delving deeply into the subject, it quickly became how I made decisions in the market. Although I was profitable, there always seemed to be something missing in my investing, so I decided to think outside the box to discover what I was missing. What I discovered changed my investment philosophy completely and greatly improved the results.

My first realization was that I was profitable despite using technical analysis, not because of it. It was this initial understanding that forced me to look critically at technical analysis to separate truth from hype.

If you are a technical analyst, you are not going to like many of things I have to say. I think technical analysis has its place, but it's not the way 98% of all investors utilize it.

1. The Past Does Not Equal The Future
Every investment is required by the SEC to carry the disclaimer that past performance does not equal future results. While it seems like an obvious statement, technical analysts believe the opposite. By using charts, you are using past price to forecast future prices. Remember, no matter how fast your chart is, it can only plot prices that exist in the past. You can't trade the past. The SEC understands this and tries to warn investors, yet most don't listen. The reason for this is...

2. Hindsight Bias
Hindsight bias is the human tendency to project the past into the future. If you have ever looked at a chart thinking that only if I had bought here and sold there, I would have made a fortune, you are guilty of hindsight bias.

Also, the way charts make investing appear so easy (buy the lows, sell the highs) is part of hindsight bias. This delusion must be controlled if you wish to be a successful investor.

3. Investor Psychology Does Not Move Price
Technical analysis is built upon the premise that price is a reflection of investor mood or psychology at any given time. While, at one time, this may have been accurate, today it is completely wrong.

Money moves price. With the advent of hedge funds and other large institutional players, a single trader can control the price of a stock. There are multiple reasons why a hedge fund manager might decide to buy or sell a stock. There is no way to tell when or why a mass of money will come into a stock.

Unless you believe that technical analysis can predict when the big dogs will buy or sell, it simply makes no sense as a standalone decision-making tool.

4. Charts Can Be Deceiving
Price charts appear different depending on how they are scaled and other factors. What may appear to be an upside price breakout to one investor may look like a breakout failure to another. It all depends on the scaling of the chart.

Also, it's very easy to project your own biases onto a chart, resulting in self-delusion about price rather than objective analysis.

An interesting way to prove the deception of charts is to look at charts created by random number generators. These random charts look exactly like financial price charts!

5. Very Limited Academic Proof
There is very little objective proof that technical analysis provides an edge in the stock market. Most studies indicate that entries and exits via technical analysis provide no better returns than could be expected from randomness.

OK, now that I laid out the case against technical analysis, is there any value in using it at all? Yes, of course!

Technical analysis is perfect for scanning large numbers of stocks to locate those that fit certain criteria for further research. Secondly, technical analysis makes sense as a tool to compare stocks to each other in context.

Risks To Consider: All investing is risky. Always use stops and position size properly regardless of your investing method.

Action To Take: If you are a diehard technical analysis lover, think critically about what you are doing. Ask if you are truly happy with your results. If not, then it may be time to reconsider your approach.

Editor's Note: It's the most surprising portfolio most investors won't invest in... though some of these blue-chips have doubled the market each of the past three years. Click here for the full report.

David Goodboy does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.