If you’ve ever seen a portrayal of a day trader or other passionate, focused investor in pop culture, you’ve likely seen them staring at seven different monitors, studying graphs and numbers like a super genius. They probably studied patterns at a glance and were capable of almost instinctively predicting the next changes in price for a given, unnamed asset.
In some ways, this is an illustration of technical analysis—the art of studying price, volume and other market variables to predict the future course of a given asset. But just how important or effective is technical analysis? And do you really need it to become a successful investor?
The basics of technical analysis
Let’s start with a basic explanation of technical analysis. Technical analysis attempts to take quantitative, measurable information about the market and transform it into predictions. As a simple explanation, let’s say that historically, the price for stocks in a given industry tend to follow a set pattern of ups and downs, ultimately ending with a sharp rise in price. If you see a stock in this industry following the early stages of the pattern, you could hypothetically time your purchase at the bottom and capitalize on the spike to the top.
In practice, technical analysis is much more complicated than that. With advanced techniques like candlestick chart analysis, a skilled investor can learn much more about the history (and future) of an asset than an average investor. This allows them to make faster-paced and better informed decisions, which gives them a clear advantage.
But as you might suspect, technical analysis isn’t always a strict advantage.
Complexities associated with technical analysis
We can’t determine technical analysis to give investors a perfect advantage over investors who don’t use technical analysis, for several reasons:
- Skill, experience and room for error: First, we need to acknowledge that technical analysis in the hands of a skilled trader with 40 years of experience is much different than technical analysis in the hands of a 19-year-old who just Googled the concept three days ago. It’s also possible for anyone, even the most experience professional, to execute a technical analysis incorrectly or with the wrong assumptions. Because of this, technical analysis can hypothetically lead people to bad investment decisions as much as it can lead them to good ones and shouldn’t be considered an absolute path to investment success.
- The efficient market hypothesis: The efficient market hypothesis is the idea that share prices in the market always reflect all available information, and that only new information has the power to move share prices. In other words, if a technical analysis reveals that a stock should be poised for growth in the immediate future, you can consider that information publicly available—and you should count on that information already being “priced in” to the stock. In the context of this hypothesis, it’s practically impossible for an individual to consistently outperform the overall market with market timing or expert selection of stocks. This undermines the true value of technical analysis.
- Short-term trades: Technical analysis is often reserved for making short-term trades and optimizing for short bursts of growth, in contrast to the long-term buy-and-hold strategies executed by many average investors. This is both a strength and a weakness; if harnessed properly, short-term trades can help you achieve more profitability, but it can also expose you to more risk. In the context of long-term investment and buy-and-hold strategies, technical analysis isn’t a strict necessity.
Basic vs. advanced technical analysis
While advanced technical analysis will seem overwhelming to the average investor, the basics are easy to grasp—and can be employed as part of almost any investing strategy. After all, technical analysis is simply the study of market variables like price and volume.
For example, if you’ve ever looked at a line chart of a stock’s historical performance, you’ve done a kind of technical analysis. You may have noticed that the stock tends to regularly surge in response to quarterly earnings reports; while this isn’t a perfect predictor of future results, you may use this as a factor in your next investment decision.
In this context, technical analysis is an important and worthwhile tool in any investor’s toolbelt.
The bottom line
Technical analysis is a valuable strategy for making better investment decisions, but it’s not a strict necessity for all traders. If you’re interested in a hands-off, buy-and-hold approach, purchasing reliable blue-chip stocks and broad market index funds, technical analysis isn’t going to help you much. But if you want to make smarter, more objectively grounded investment decisions in individual companies, or if you want to trade higher volumes in a short-term capacity, technical analysis is an absolute must-learn skill.
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