The Logic Behind Technical Analysis
Below is a MRR and PLR article in category Finance -> subcategory Other.
The Logic Behind Technical Analysis
Introduction
Though I don't engage in technical analysis and never have, I can acknowledge its potential predictive value. The Efficient Market Hypothesis (EMH), which suggests that all available data determines market prices, has its flaws. As Benjamin Graham pointed out, the market behaves more like a "voting machine" rather than a "weighing machine." This highlights the influence of speculative factors and human sentiment on prices.
Market Complexity
The market often resembles a funhouse mirror. The original data shapes what we see, but the reflection is not always a true representation of that data. The EMH assumes the data creates the market's reflection, failing to recognize that interpretation plays a crucial role. This oversight leads to misconceptions, like the idea that falling prices destroy wealth while failing to account for buyers and sellers in every transaction.
The Role of Interpretation
The EMH doesn't account for how interpretation affects market prices. While empirical evidence questions technical analysis’s utility, this doesn’t definitively prove it lacks predictive power. Just as a unique pitching style like the knuckleball might be effective if mastered, technical analysis could similarly have its merits.
Understanding Randomness
Randomness is often misunderstood. Carl Menger noted that all events follow the law of cause and effect. Therefore, nothing is truly random, though patterns may be indiscernible. Stock prices are driven by purposeful human actions, suggesting that past movements influence future ones.
Technical Analysis vs. Fundamental Analysis
Given that investor actions affect prices, past price movements partially cause future changes. Thus, technical analysis is logically valid and may possess predictive power. However, I prefer fundamental analysis, which I find more powerful and informative. There's ample fundamental analysis to engage any investor, leaving little room for technical analysis.
A Practical Model
Although I believe some form of technical analysis must work, I exclude it from my investing model because I find fundamental analysis more useful. I choose to pretend technical analysis lacks utility, despite knowing logically it might have predictive power. This approach isn’t unique; in science, we use models that simplify concepts like randomness or the role of zero, even if they’re not entirely accurate.
Conclusion
I suggest adopting a similar mindset towards technical analysis. Acknowledge its logical validity, but construct a mental model of investing where it holds no utility. This model, while not fully comprehensive, may prove to be the most practical and effective in the realm of investing.
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