Investing Alchemy

I love to look at stock charts. It is tempting to believe that I can tell where a stock is going based on where it has been. It's one of my weaknesses as an investor, but I bet I'm not alone.

I'm sure at one time or another you've seen a stock that has been cut in half in a month. That steep, downward-sloping line looks like a great opportunity. Surely, Mr. Market is overreacting, and we had better get in on this bargain while it lasts. Right?

Or a certain stock has been on a rocket ride and has no signs of slowing down. The momentum seems unstoppable. Is now the time to get on board?

You probably realize that this line of thinking is hazardous to your wealth. So why do we all do it? Maybe it's because of human nature, which makes us see patterns where they don't exist. A college buddy of mine will wait for a string of reds at the roulette wheel before plunking money down on black. "Black is due," he'll say.

That's why charting may not be a serious strategy for the average investor.

Reading the tea leaves
Interpreting stock charts is commonly known as technical analysis. Technical analysts believe the market is highly influenced by psychological factors. Charts show how investors have acted in the past, which should shed some light on how they will react in the future. Earnings, dividends, cash flow -- these matter not to the technical analyst. What matters is trends -- and how to capitalize on them.

The chartist uses fancy names for common formations that arise in a stock chart: "double bottom," "resistance points," and "buying climax." These formations tell the chartist when to buy or sell. Better still, he does not even have to open an annual report!

No doubt there are investors making money -- probably lots of it -- from technical analysis. I wish them luck. In fact, Renaissance Technologies has remained one of the most successful hedge funds by using complex computer models to predict future price movements. But Renaissance employs Ph.D.s in fields like astrophysics and mathematics. Can the average investor hope to use these sophisticated techniques? For every technical analyst bragging about his success, how many more have been burned trying to interpret charts?

Random walking
Most academic studies are skeptical about the merits of technical analysis. Any small advantages gleaned from charts are quickly lost when factoring in broker commissions and taxes. A long-term, buy-and-hold strategy is often far superior.

Burton G. Malkiel systematically tears down technical analysis in his classic work A Random Walk Down Wall Street (my favorite investing book, by the way). Using rigorous studies, Malkiel shows how past price movements do not give any useful indication about what will happen in the future, even over short periods of times. Even if there were some secret formula for interpreting charts, it would be rendered useless once it was discovered by investors. Which is to say, when everyone employs the same investing strategy, stock prices adjust until that strategy is no longer profitable.

See for yourself
Not convinced yet? Well, we don't need any highfalutin academic studies to see the follies of technical analysis. Here's a simple test we can do on our own.

What would have happened if you had invested in some of 2004's best-performing stocks on Jan. 1, 2005, and held them for one year? These stocks had strong momentum going into 2005, and psychological factors were at play. Could technical analysts have profited?

Annual Returns

2004

2005

Coldwater Creek

321%

48%

Sears Holding

313%

168%

Apple Computer

201%

123%

Cleveland-Cliffs

308%

71%

Elan

296%

-50%

Martha Stewart Living Omnimedia

195%

-40%

AK Steel Holding

184%

-45%

Research In Motion

147%

-20%

First Marblehead

157%

-42%

Sirius Satellite Radio

141%

-12%

Lion's Gate

137%

-28%

Wynn Resorts

139%

-18%



Data provided by Capital IQ, a division of Standard & Poor's.

At best, the results can be described as a mixed bag. Coldwater Creek (Nasdaq: CWTR  ) , Apple (Nasdaq: AAPL  ) , Sears Holdings (Nasdaq: SHLD  ) , and Cleveland-Cliffs (NYSE: CLF  ) had fantastic years in both 2004 and 2005. The technical analyst would be patting himself on the back had he recognized and invested in these trends.

But the wheels were coming off other businesses after they had built momentum in 2004. Martha Stewart Living (NYSE: MSO  ) took a 40% dive on substantial losses, and First Marblehead (NYSE: FMD  ) dropped 42% over concerns about relationships with clients Bank of America and JPMorgan. Biotech company Elan (NYSE: ELN  ) had a startling 90% haircut in the spring of 2005 when its potential blockbuster drug Tysabri was pulled off the market. It finished the year down 50%.

What's a chartist to do?
Admittedly, more work goes into technical analysis than looking at last year's winners. But the fact remains that investors could not have foreseen these events from a chart alone. No matter what the final results of our simplified experiment may have been, this is a risky way to invest your hard-earned dollars.

Technical analysis is certainly appealing, but it's not for me. I don't have a Ph.D. in mathematics, and I'm not yet sold on the merits of so-called investing alchemy. I prefer to follow master investors like Warren Buffett by learning about a great company, buying it at a good price, and holding it for the foreseeable future. I find it to be a more rewarding experience (and more lucrative) than sweating past trends.

The Foolish bottom line
If you ever have the urge to read the tea leaves buried in a stock chart, just do what I do. Put down that chart, take a deep breath, and remember that great investment decisions come from understanding the business. It's hard work, but don't worry. It doesn't have to be solo work.

One place you can start is with Fool co-founders David and Tom Gardner, who have been helping investors make better decisions for years through their Motley Fool Stock Advisor service. They'll bring you two stock ideas each month and show you how to analyze the firm's prospects, management, competitors, and financial situation. No secret formulas here, just thorough research and intelligent insights. And I promise you will never hear Tom or Dave utter the words "double bottom."

To date, David and Tom's Stock Advisor picks are beating the S&P 500 by nearly 40 percentage points on average. Click here to learn all about a free 30-day trial to the service.

Joseph Khattab is a Motley Fool research analyst. He does not own shares in any of the companies mentioned. JPMorgan and Bank of America are Motley Fool Income Investor recommendations. The Fool has a disclosure policy.


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