Reading Stock Charts: Serious Business
When it comes to reading charts, stock analysts generally follow two distinct schools of interpretation. Fundamental analysis studies the intrinsic value of stocks by examining various factors such as:
- Sales numbers.
- Economic conditions.
- Financial management.
Technical analysis, by contrast, focuses on patterns in a stock’s price and trading volume. It is rooted in the principle that the fundamentals are already incorporated into the price. While these techniques may seem at odds, knowledgeable investors often rely on both as forecasting tools.
Investors can be their own worst enemies
As victims of our own egos, we all make self-serving excuses and sacrifice discipline to protect our self-esteem. Behavioral economists have identified many of these irrational biases as distortions that lead us away from hard evidence. For example, investors resist selling their losing positions because they hate to feel foolish. Or they may cling to a past purchase price, emotionally tethered to the level at which they entered their position.
Let’s revisit the irresistible urge to get out even. Markets often trade in a range between support and resistance levels. Why? Think of teams of bulls and bears on either side. After a stock breaches a resistance level on the way up, perhaps only a few bears will remain, and those who do hang on are suffering losses. As they lick their wounds, the psychology shifts. Some of the beleaguered bears may even decide to take their lumps. They may decide to be nimble and jump on board with the bulls. The resistance ledge becomes a battle in collective memory. It now represents the winners’ gains and the losers’ pain in the struggle to confirm the directional trend.
At these inflection points, round numbers also exert a psychological pull. Buyers and sellers place more orders as a stock approaches a round number, prolonging the efforts to move beyond it. Remember all the hoopla and celebratory baseball caps when the Dow Jones Industrial Average first crossed the 10,000 threshold in 1999? (Maybe not. It was a while ago!)
In a trading range, recognize when it is time to get out. A vulnerable ego may once more refuse to let you recognize a mistake, or sheer greed may keep you invested too long. Don’t fall in love with a stock once you have bought it, and still keep following its progress. You may find it easier to execute a sell decision if you note the technical signs.
Price is true
While fundamental analysis zeroes in on price-to-earnings ratios and other related metrics, technical disciplines largely concentrate on price and volume. Traders traditionally say, “price is true,” a reminder that it is more important to be profitable than to be right. Your analysis can be flawless, but if the market is pitched against you, you are losing money.
Price may indeed be true, yet skilled technical analysts can sometimes even use their toolkits to see beyond price. For instance, they use indicators called oscillators to determine the boundaries of a range and gauge good exit and entry points. Oscillators also act as shock absorbers, revealing the best way to handle news as it hits the tape. When an indicator is overbought, it suggests good news may have less impact and vice versa. When it is oversold, even a whiff of good news makes an impression.
Savvy investors rely on a hybrid of technical and fundamental approaches to achieve the best-informed results. Ideally, the two methods should complement each other.
Ironically, many fundamental forecasters are unwitting closet technicians. They too manipulate corporate inputs with mathematical functions. They might be looking for momentum, acceleration or deceleration in earnings or sales. They might smooth earnings into a moving average for a visual picture that evens out data points.
The two camps share many common underpinnings. Humans yearn for pattern recognition and seek to impose meaningful shapes and stories. The naked eye can often spot simple patterns better than a computer can. A glance at a technical chart can sometimes outperform powerful hardware.
Talk to your financial adviser to learn more about how to build your portfolio using all the tools in the box.