Stock market technical indicators can help you find stocks worth buying—but they are just one tool of many you will need to use

Before you let trading rules or stock market technical indicators influence your investment decisions, it’s a good idea to check them for signs of the Gambler’s Fallacy. This is a logical error that gamblers make, but it also turns up in a lot of investor thinking. The simplest way to explain it is to show how it works in a coin toss.

Often, people intuitively feel that after heads comes up in a series of coin tosses, the next toss is increasingly likely to come up tails. Without getting technical about it, they are mistaken. That’s because each coin toss is an independent event. It has a random outcome with 50-50 odds of heads or tails.

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Don’t mistake positive stock market technical indicators for sure things

People understand that 50-50 odds means that heads and tails must come up in equal numbers over long periods. But some fail to appreciate that the next coin toss is always an independent, random event. Random events vary unpredictably, and they commonly occur in unpredictable bunches. A 100-toss string of heads would be extremely rare. So would a 100-toss string of tails, or a 100-long string of heads-tails-heads-tails-heads-tails.

In university, it didn’t take me long to see how this applied to coin tosses. I wish I could say I was just as quick to grasp the investing implications. Instead, like many beginning investors, I spent a lot of time over the next couple of decades on trading rules, market indicators and so on.

It seemed they all worked, at least for a while. They kept working until they quit working. This switch could happen over a period of years, or overnight.

In many cases this is because the rules and indicators depend on past records of price changes and other statistics that come with a large random influence. These statistics weren’t totally independent of each other, like the individual outcomes of a series of coin tosses. But they also weren’t causing the profits they were supposed to generate, nor predicting them. They were just coincidences.

Every one of them seemed to come with a record of success. But the closer you looked, the more these records wilted. Many depended on cleverly cherry-picked start and end dates for the period(s) under study.

Often these periods included at least one hugely successful win. This windfall had to be big enough to raise the otherwise average profit performance to an eye-catching level. A surprisingly slight change in the start and/or end dates often was enough to eliminate the rule’s payoff, or replace it with a loss.

Studying investment rules and indicators indirectly tells you something about the impact of conflicts of interest on investment advice. Many trading rules and indicators get created for commercial reasons—to sell a book or investing course, or to sign up customers for a trading or investing program. Rules and indicators may start out as research. On the way to market, they turn into marketing materials.

This is an all-too-human transformation, and not just in investment research. Conflicts of interest, personal beliefs, prejudices and so on can warp all kinds of research studies and lead to tainted conclusions. That’s true in academia and science, as well as in finance.

Scholars and scientists rely on the scientific method to keep human nature from tainting their work. One key part of the method is reproducible experiments. Science moves forward when scientists can repeat each other’s experiments and get the same results.

Now, however, scholars and scientists find what they face a crisis of irreproducibility, particularly in the life and social sciences. Many experiments that have been published in respectable scientific journals turn out to be irreproducible—duplicating the experiment generates conflicting results.

In other words, it’s not just investment types who are fudging the results to make them look better.

Your best approach with investment rules or indicators is to take a skeptical view. Before you act on them, look for a rationale for why they might work, rooted in economics or human nature.

Use stock market technical indicators in conjunction with other tools to make more rewarding stock picks

When you come right down to it, you have two ways to try to profit from stock market indicators. The most common, and the favourite of many investors who are just starting out, is what you might call “the crystal-ball approach.” That’s when you look around for a simple-to-understand, fits-on-a-T-shirt indicator that provides a clear buy-or-sell signal.

The crystal-ball approach will give you random results—a series of wins and losses. In the long run, however, a random approach to investments is more likely to hurt than to help you, just as in any other area of life.

Instead, our Successful Investor approach to indicators is to use them as specialized tools, rather than decision-making devices. Before you rely on a technical market indicator, you need to consider the information it employs and decide if that slice-of-all-available-info is important enough to provide a clue to the outlook for the market or individual stocks.

Use our three-part Successful Investor approach to confirm findings you make using stock market technical indicators

1. Hold mostly high-quality, dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight.

Do you use technical analysis to help you choose stocks, or do find they exclude too many key factors?