Technical analysis (or reading stock market charts) can be a useful tool for picking stocks. However, some investors choose to make investment decisions based solely on charts. That’s when technical analysis can lead you to make poor (and sometimes disastrous) choices.
Technical analysis is the process of analyzing a stock’s price movements in an attempt to determine its future price. It focuses on how a stock has behaved in the past, and the clues that could offer about future price movements.
It’s crucial to keep stock market charts in perspective
We always look at stock market charts when we select stocks to recommend in our newsletters and investment services. And some successful investors find it helps to know a little about charts. But if you rely on charts at all, you should view them as just one of many things to consider when you make investment decisions. Here are two reasons why:
1. Technical analysis zeroes in on share prices: The main problem with chart reading is that it is based entirely on a stock’s past price movements. It’s not concerned with other crucial parts of a company’s business, such as financial statements, management strength or conditions in the company’s industry. In fact, an investor who relies solely on charts might buy and sell a stock while knowing little or nothing about the underlying company.
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2. Technical analysis is not as consistent as it appears: The appeal of technical analysis is that it often seems to work, at least in small ways, but this may be an illusion. You may only remember your successful chart interpretations. More important, technical analysis tends to work in spurts. The risk here is that you may find it leads you to make five or even 10 small wins, then steers you wrong at the worst possible moment. That next mistaken trade may cost you much more than your winnings to date.
Stock market charts should support — not determine — your view of a company
The key to profiting from technical analysis is to avoid looking to the pattern on the chart for a prediction of what’s going to happen. Instead, see if the chart seems to support your view of the stock, based on its finances and other fundamentals.
It’s encouraging if your analysis and the chart seem to match. But sometimes they don’t. If a stock looks promising, but its chart shows a lengthy falling trend, insiders may know something you don’t. That’s when you have to dig deeper, and perhaps wait until the situation clarifies itself.
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