In the last couple MarketPulse articles, we’ve touched upon one of the oldest debates in the history of the markets: Which is better – Technical Analysis or Fundamental Analysis?
Our argument was for the superiority of the former over the latter. We noted that technical analysis is the study of price and price trends and is therefore far less subjective than fundamental analysis which is the study of value. This is because price is there for all to see, it is the undeniable final measure of a security’s current worth. Value on the other hand, like beauty, is in the eye of the beholder.
Investors who follow value are thus far more prone to hanging on to a security whose price is falling. Often they do so because they believe (hope) that the the security’s ‘value’ will eventually be reflected in the market and rightfully deliver them a subsequent profit. Conversely, value investors are likely to sell a security whose price had spiked significantly above their perceived view of value as the security would now be considered expensive.
Technical analysts prefer to invest their money in the exact opposite fashion to the scenarios described above. As a student of price, a technical analyst will prefer to sell or short sell securities with falling prices. Their view is that the only way to make money from falling prices is not to hang in hope of a recovery, but to be a short seller and profit from those falls. On the other hand, the good technical analyst will buy securities which have seen large price spikes. They view these spikes as likely precursors of further spikes to come.
To summarise, the fundamental analyst buys low and hopes to sell high. They will also sell high and hope to buy back low. The technical analyst on the other hand prefers to buy high, but with the confidence that they will soon be able to sell even higher. Instead of attempting to buy low, the technical analyst prefers to short sell low, but with the confidence that they will soon be able to buy back even lower again.
For many novice investors, the fundamental analyst’s strategy seems to make the most sense and the technical analyst’s approach seems counterintuitive. Surely buying low and selling high, and selling high and buying low, is the best way to make money in the markets? Surely this means that we would be buying stocks when they are ‘cheap’ and selling them when they are ‘expensive’? What many fail to realise however, is that by doing so one is forgetting the most important tenet of investing: Always follow the trend. (In last week’s MarketPulse we defined how to identify the trend and various stages of the trend).
When buying a security when prices are low, the investor is buying in a likely down trend. Buying in a down trend is a low probability play as prices have been falling for a very good reason. When selling when prices are high, the investor is selling in a likely up trend. This is an equally low probability play as prices have been rising for a very good reason. In each case, trading against the trend will likely deliver the investor losses more often than not.
Where all too many investors trip over is that they confuse a low price with something being ‘cheap’. Similarly, they confuse a high price with something being ‘expensive’. The reality is, in the markets no one person actually knows when things are cheap or expensive – nor could they do anything about it even if they did. This is because the determination of ‘cheap’ or ‘expensive’ occurs with the market as a whole: A market made up of millions of often irrational investors driven by fear and greed!
What keeps us safe in the markets is the trend. It cuts through all of the confusion to tell us which is the safest way to trade at any one time – long or short. There are few professional investors in the market who would argue that following the trend isn’t crucial to successful investing. It’s the first thing most novices are taught: The trend is your friend.
Yet, looking at the above scenarios, it seems that fundamental analysis and its study of value often causes investors to trade against the trend. Technical analysts on the other hand are trained to seek out the trend and are therefore far more likely to achieve success in the markets.
We’ll explore this concept further and define exactly why it is prudent to trade with the trend in next week’s MarketPulse article.
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