Welcome to an exciting episode of The Winning Investor’s Quick and Dirty Tips for Beating the Market. I'm your host, Andrew Horowitz.
So far, we've been discussing how to select stocks based on fundamental analysis or ratios. We’ve talked about the PE ratio or the PEG ratio. By doing this, we're trying to find stocks that are undervalued relative to similar stocks so that we can buy them and hopefully gain a profit.
This time, in this episode we want to add another component to the process by introducing technical analysis. I know the words "technical analysis" make the process of evaluating stocks sound intimidating or complicated, but it is actually much easier than you think. Remember, we're trying to keep things simple and helps to put the odds in your favor to become a winning investor over time.
What is Technical Analysis?
In my book "The Disciplined Investor," and if you haven’t gotten a copy head on over to Amazon to pick it up, I defined technical analysis the following way: “Technical Analysis is the use of historical statistics of investment supply and demand to discover and exploit stock price patterns.”
We don't limit technical analysis just to stocks. No, we do things like market indices, exchange traded funds, commodities, bonds and a whole host of other things that we can actually chart.
Some people call technical analysis "voodoo" because it’s trying to figure out future price movements from past price movements of a stock or a bond or an ETF and looking at their price and volume to see how they play out. Some even compare it to reading tea leaves, but it actually can be quite useful if used as part of a larger investment strategy.
Why Should You Use Technical Analysis?
There are three basic tenets as to why technical analysis is important in helping us select stocks.
? First:Markets have trends. The basic assumption is that once a trend is established, the trend will continue in the same direction because of a supply and demand imbalance. A trend is simply defined as prices moving in one direction -- up or down -- for a lengthy period of time -- maybe weeks or months. That means we can look backwards in time to see the direction of the price movement and then assume that direction will continue at least for a time.
This also means that if we're looking at two fundamentally similar stocks, we would prefer to invest in the one that had an uptrend as opposed to another that might be in a downtrend.
? Second:Markets are efficient. What does "market efficiency" mean? It means that all that can be known is already factored into the price of a stock. Markets look forward and "price in" or "discount" all available the fundamental information about earnings, growth, competition, debt, and other economic factors very very quickly. That assumption helps us because we can assume that the current price is efficient or reflects all available data -- we can trust the current price as fair. Inefficiencies don't last long when they exist, and price will return to fair value quickly as new information enters the system.
Think back to how many times you've seen a stock price rise or fall unexpectedly, and then a few days later, we find out what happened through the news. Remember that it takes time for news to reach the public, and people who hear the news first will act on it and that action will be reflected immediately in the stock’s price.
?Third: History repeats itself. I'm sure you've heard the saying "Those who do not know history and who haven’t studied history are doomed to repeat it." Well, that's also true in the market! We see certain cycles and long term price patterns that tend to repeat. People who study charts have classified these patterns and given them names like a head and shoulders, flag, saucer, triangle, and many more. Patterns reflect human behavior as they react to information in the market -- and let’s not forget that people tend to be emotional when it comes to money! Think of your own experience -- you probably react the same way to the same conditions each time they happen in your own life. People tend to react similarly when trading and investing in the market. That's part of what causes price to rise quickly and fall quickly, and the charts leave little footprints of this behavior.
These actions and reactions translate into buy and sell events, or signals, that show up on price charts. People who study charts are trying to locate these price patterns and find out what is likely to happen next, or at least get an early signal as to whether to enter or exit a position.
Stay tuned for next time when we discuss what to look at when you view a stock price chart!
And as always, if there a question you’d really like to ask just email me at winninginvestor@quickanddirtytips.com or call 206-338-0836. That’s 206-338-0836 and maybe your question will appear on the show. And if you like the show, tell a friend and leave a review on iTunes. This is Andrew Horowitz with the Quick and Dirty Tips for the Winning Investor. Talk to you soon.
