I love to look at stock charts. It's tempting to believe that I can tell where a stock is going based only on where it's been.
I'm sure that at one time or another, you've seen a stock get cut in half. That steep, downward-sloping line of Doral Financial (NYSE:DRL) could be a great opportunity. Surely, Mr. Market is overreacting, and we had better get in on this bargain while it lasts. Right?
You probably realize that this line of thinking is hazardous to your wealth. So why do we all do it? Maybe it's human nature, which makes us see patterns where they don't exist.
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 doesn't even have to open an annual report!
There are doubtlessly 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. After all, when everyone employs the same investing strategy, stock prices adjust until that strategy is no longer profitable.
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 investor Warren Buffett, who identifies great companies like Moody's (NYSE:MCO), buys them at good prices, and holds them for the foreseeable future. I find it to be a more rewarding experience -- and a more lucrative one -- than sweating past trends.
Further fundamental Foolishness:
David and Tom Gardner stick to good ol' fashioned fundamental analysis to pick winning stocks. Try out Motley Fool Stock Advisor to see their best recommendations. Moody's just happens to be one of them.
Doral is a former Inside Value recommendation. This article was originally published on January 24, 2006. It has been updated. Fool sector editor Joey Khattab does not own shares in any of the companies mentioned. The Fool has a disclosure policy.
