"Beware of technical analysis, my son! The jaws that bite, the claws that catch!" Had Lewis Carroll been an investing aficionado, he might have cautioned investors about technical analysis instead of the Jabberwock and the Jubjub bird. He didn't, though, so permit us.
Technical analysis is often contrasted with fundamental analysis. Technical analysis dwells on charts of stock price movements and trading volume. Fundamental analysis, on the other hand, focuses on the value of companies, studying such things as a firm's business, earnings, and competition. While investors from the fundamental school want to understand a business from the inside out, technicians mostly remain on the outside, observing how the stock behaves in the market.
Technicians have defined many patterns in the charts they study, imbuing them with much significance. There's already a head-and-shoulders pattern and a cup-and-handle pattern. Perhaps next we'll see an ostrich-and-eggbeater pattern. These patterns do exist, but they don't necessarily mean anything. Imagine someone discovering that on presidential election days, whenever the skies above Fresno were cloudy, Republican candidates won. Like many patterns, this would be a randomly occurring one, a coincidence. For you to bet any of your hard-earned savings on this would be nothing more than gambling.
Investors who use technical analysis are really betting on the psychology of the market as they scrutinize investor behavior. They try to determine where the big, institutional money is going so they can put their cash in the same places. Imagine Warren Buffett, chairman of Berkshire Hathaway (NYSE: BRK.A, BRK.B), trying to follow this short-attention-span crowd instead of seeking, buying, and holding great companies for the long term. Imagine the taxes and commissions. Yeesh.
It's amazing to think that technicians might study a stock chart, see a particular pattern, determine that the stock is "breaking resistance," and then buy shares. All this would very possibly be done without ever understanding what the company does or what its prospects and circumstances are.
Most of us at Fool HQ prefer to focus on the fundamentals. If you find a company quietly selling more and more prefab igloos, increasing its profit margins and earnings, trading at a discount to its intrinsic value, and going unnoticed by Wall Street, consider snapping up shares. Don't worry about what others are doing. The true value of great companies is eventually recognized.
If you want to hear opposing points of view, drop into our Technical Analysis Trading discussion board (free trial available).
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