Weaknesses of Technical Analysis
Analyst Bias
Just as with fundamental analysis, technical analysis is subjective and
our personal biases can be reflected in the analysis. It is important
to be aware of these biases when analyzing a chart. If the analyst is a
perpetual bull, then a bullish bias will overshadow the analysis. On the
other hand, if the analyst is a disgruntled eternal bear, then the
analysis will probably have a bearish tilt.
Open to Interpretation
Furthering the bias argument is the fact that technical analysis is
open to interpretation. Even though there are standards, many times two
technicians will look at the same chart and paint two different
scenarios or see different patterns. Both will be able to come up with
logical support and resistance levels as well as key breaks to justify
their position. While this can be frustrating, it should be pointed out
that technical analysis is more like an art than a science, somewhat
like economics. Is the cup half-empty or half-full? It is in the eye of
the beholder.
Too Late
Technical analysis has been criticized for being too late. By the time
the trend is identified, a substantial portion of the move has already
taken place. After such a large move, the reward to risk ratio is not
great. Lateness is a particular criticism of Dow Theory.
Always Another Level
Even after a new trend has been identified, there is always another
"important" level close at hand. Technicians have been accused of
sitting on the fence and never taking an unqualified stance. Even if
they are bullish, there is always some indicator or some level that will
qualify their opinion.
Trader's Remorse
Not all technical signals and patterns work. When you begin to study
technical analysis, you will come across an array of patterns and
indicators with rules to match. For instance: A sell signal is given
when the neckline of a head and shoulders pattern is broken. Even though
this is a rule, it is not steadfast and can be subject to other factors
such as volume and momentum. In that same vein, what works for one
particular stock may not work for another. A 50-day moving average may
work great to identify support and resistance for IBM, but a 70-day
moving average may work better for Yahoo. Even though many principles of
technical analysis are universal, each security will have its own
idiosyncrasies.
Conclusions
Technical analysts consider the market to be 80% psychological and 20%
logical. Fundamental analysts consider the market to be 20%
psychological and 80% logical. Psychological or logical may be open for
debate, but there is no questioning the current price of a security.
After all, it is available for all to see and nobody doubts its
legitimacy. The price set by the market reflects the sum knowledge of
all participants, and we are not dealing with lightweights here. These
participants have considered (discounted) everything under the sun and
settled on a price to buy or sell. These are the forces of supply and
demand at work. By examining price action to determine which force is
prevailing, technical analysis focuses directly on the bottom line: What
is the price? Where has it been? Where is it going?
Even though there are some universal principles and rules that can be applied, it must be remembered that technical analysis is more an art form than a science. As an art form, it is subject to interpretation. However, it is also flexible in its approach and each investor should use only that which suits his or her style. Developing a style takes time, effort and dedication, but the rewards can be significant.
Even though there are some universal principles and rules that can be applied, it must be remembered that technical analysis is more an art form than a science. As an art form, it is subject to interpretation. However, it is also flexible in its approach and each investor should use only that which suits his or her style. Developing a style takes time, effort and dedication, but the rewards can be significant.
