Does Technical Analysis Work?

In most books on investing, we often read about technical analysis. In fact, many investment books devote a considerable portion of the book on technical analysis. Why is because most writers know that people are seeking fast profits in the stock market, not necessarily information about how the stock market works or how to value stocks or any of the other more academic aspects of stocks.

But there is good reason to believe that technical analysis does not really work. The weak form of the efficient market hypothesis hypothecates that since past market information provides no clues about the future market, and that trades exhibit a random walk, making market prices unpredictable, technical analysis cannot be an effective forecaster. While there are many arguments for and against technical analysis, stock market bubbles and their aftermath do cast some doubt on the efficient market hypothesis and seems to support the notion that market sentiment does move the market in some ways, though fundamental data is more determinative in the long run. However, even though the efficient market hypothesis is more an idealization than a reflection of reality, this doesn't mean that technical analysis works.

But this also doesn't mean that you cannot make money using technical analysis, but it will probably be because you were lucky or that you've been looking at the stock market long enough to recognize some patterns. But even if you are successful, it does not mean that technical analysis works, it probably means that you were just lucky. After all, stocks will either go up or down, so you have a 50% chance of making profits, at least in the short term. But over a longer period of time, you will most likely even out.

So trading based on patterns will not work in the long-term, even if the patterns do seem to hold many times. Let me illustrate my point with a simple scenario. Imagine that there was a stock that would oscillate between $4 and $5 per share. When the stock reaches $4 per share, then it would climb to $5, and when it reaches $5 a share, then it declines back to $4, back-and-forth, continually. Now, you can make a lot of money trading this 1 stock, but eventually other people would also see the same pattern, and so they would start trading the stock. However, when you place an order to trade your stock, it goes into a queue, and usually, you will not be at the front of the queue. So, what happens is that the stock starts declining before it reaches $5, and it starts going up before it reaches $4. To get to the front of the queue, people will start lowering their sale price and increasing their purchase price by a few pennies. As more and more people trade the pattern, people will continue to lower their sale price and increase their purchase price to get to the front of the queue, until the repetitive pattern disappears.

Make Money by Selling Your System!

But guess what? You can still make money on the stock by selling your system. You can write a book on how to trade the stock and use stories to make the material substantial enough to compose a book, then you can make some money selling books. But you want to ensure thatyou do this after you have made as much you could from trading the stock itself, because if you told people about it before you even started, then you would not be able trade the pattern. In other words, if you truly saw a pattern where you can consistently make money, you would keep it a secret, because otherwise, your trading strategy will fail more quickly. So now you know that when you see a book that purports to show you how to make money in the stock market, the author is making money by showing you a system, but if it actually worked, he would surely keep it secret.

A famous example of what I'm talking about is Ralph Nelson Elliott. He came up with what he called the Elliott Wave Theory of predicting stock market movements, and although he made some money selling his system, there is no evidence that he ever really became wealthy actually using his system. Indeed, he was rather poor for most of his life, especially toward the end of his life. Or examine a more recent forecast. Here is an Elliott Wave evangelist warning that investors should get out of the stock market. This warning was reported in the New York Times, Robert Prechter's Market Forecast Says 'Take Cover' - The New York Times, on July 3, 2010. So, by now, you know what would have happened if you had gotten out of the stock market in 2010. By December 2019, the stock market indexes are almost triple what they were in 2010! The Nasdaq more than tripled!

And if technical analysis really did work, where you can simply look for signs or patterns to trade, then consider your competition. There are many full-fledged businesses who use high-speed computers with fast connections to trading networks, using highly trained and educated professionals devising various algorithms to trade according to those patterns. Now some of these organizations are very successful, but as I said, trading stocks is a zero-sum game, where your gain comes from someone else's loss, or your loss is someone else's gain. And when you pit yourself against professionals who spend all of their time devising these algorithms and trading the market, it is you who will lose. Indeed, if technical analysis really worked, computers would be the best technical analysts of all time and they will make the most money, because they have no emotions whatsoever. They have no fear. They have no distractions. What about you? And computers can react much, much faster. Electronic circuits can transmit signals almost at the speed of light, while the fastest neurons, the cells composing your brain, cannot transmit signals much faster than 100 mph, a tiny fraction of the speed of light.

So much is written about technical analysis because people want to make an easy dollar, but an easy dollar does not exist. Even if it did, other people would discover the same easy dollar, which would increase competition dramatically, to the point where the dollar was not easy anymore.

Another question that you must answer is whether it is worth your time and effort in trading the market. A disadvantage of stock trading is that it has no real economic value, you only profit from the losses of others. After all, trading stocks really is a zero-sum game for the most part, except in the primary stock markets, where IPOs are sold.

Make Money through Investments Easily and with Little Risk

If you want to make money in the stock market, you can do it easily without incurring a lot of risk. You can buy exchange traded funds or mutual funds that invest in the general stock market or in specific sectors, such as healthcare. By diversifying your investments, and if you use money that you do not need, then you will almost surely make money in the stock market. When you buy individual stocks, then you have to worry about whether the company might go bankrupt, but when you buy a sector, such as healthcare, you know that an entire sector will not go bankrupt. People will always need healthcare, for instance. The key is not to panic when the market goes down. If you do panic, then that is strong evidence that you are using money that you may need, and that is not a good thing. So many people incurred losses during the Great Recession because they panicked and sold at the bottom of the market. The road to riches is not achieved by selling at the bottom! Instead, you just lock in your losses. If the people who lost money during the Great Recession simply waited for a couple of years, then they would have not only avoided the losses, but also made money. The Dow Jones, for instance, peaked at 14,198 on October 11, 2007. It is now more than double that, but it surpassed 14,000 on February 1, 2013, and closed above 16,000 by November 21, 2013. Now, this is a span of 6 years, which is why it is important not to invest money that you may need in the near future.

The advantage of investing in the stock market rather than trading the stock market is that it takes considerably less personal time, which will allow you to focus on things that matter more, such as your job, or friends or family.

Usually when the market bottoms out, then it is the time to buy and hold. Prices are down because everyone is fearful, so that is the time you get into the stock market. How do you know that it is a market bottom? You don't, but over time, the market always trends upward. There may be times when it is down by a considerable amount, but it always recovers, without exception. And if you are already in the market, then you must simply hold until it recovers. This is why it is important that you have sufficient funds elsewhere, such as a savings account, that you could draw upon in emergencies. Because if it turns out that you need the money that you have in the stock market, then you may be forced to sell at a loss, which is what you want to avoid.

It is also very important that you do not use margin, because if you use debt to finance stocks, then you will be more fearful than you otherwise would be, which may cause you to sell at a loss.

Another thing you must avoid is worrying about what financial publications say. When you go to a news site, such as the Wall Street Journal or MarketWatch, you will often hear professionals advocating to buy or to sell, and often within the same timeframe. You must remember that you do not know why they are advocating what they are advocating. For instance, if the famous stock market manager is heavily invested in stocks, he may think the market will decline, so he will tell you to buy, so that he can sell his own stock at a profit. By simply buying and holding, and using money that you do not need, then you do not have to fret about the stock market, because it always trends upward, so in the long run, you will be much better off. Indeed, if you do buy-and-hold, then the stocks will probably appreciate for a while, so that when they do decline, it won't cause you nearly as much fear, because you will still be in the money, as they say.

If you want to avoid market downturns, one thing that you can do is monitor the economy. The stock market is like the weather, you never know what it will do on any particular day, but there is a pattern, a trend. The market does go up for a considerable amount of time, but it does not go up forever. One way that you can forecast a market downturn is to observe how the economy is doing and the level of debt held by consumers and businesses. If the economy shows signs of faltering, then that would be a good time to get out of the stock market. Indeed, the Federal Reserve often raises interest rates to cool an overheated economy, so when it does, what you can do is take your money and buy long-term Treasuries. You will earn interest virtually without any credit default risk. Hold the Treasuries until the market declines. Because when the economy tanks, then the Federal Reserve lowers interest rates to stimulate the economy. But lower interest rates cause bond prices to rise, because the interest rate is inversely proportional to the bond price. So you make money not only from the interest, but you can earn money from capital gains by selling the Treasuries after the Fed has lowered interest rates to its lowest point.

To illustrate how you earn capital gains with bonds, take a $1000 Treasury bond paying 6% interest. While you hold the bond, you will be paid 6% of the principal annually, but if the economy tanks, and the Feds lower interest rates close to 0%, as they did during the Great Recession, and market interest rates decline to, let's say, 2%, then your Treasuries will increase in price to more than $3000. This happens because you have long-term Treasuries that are paying 6%, but now the market interest rate is 2%, so you can sell your bond for a higher price for which the $60 annual interest payments will correspond to 2% of the bond price. This is why bond prices move inversely to interest rates. When interest rates are high, then bond prices are low, and vice versa.

Then when interest rates do not look like they will go lower and when the economy looks like it is at the bottom, then sell your bonds, then re-invest in the stock market. Prices should be low because people who needed the money in the stock market or who bought on margin have sold out of fear and locked in their losses, allowing you to buy stocks back at significantly reduced prices.

Another benefit to owning stocks is that you can save considerable money in taxes. When you buy or sell stocks or exchange traded funds or something similar, then the earnings are subject to a capital gains rate. If you hold the security for longer than 1 year, then any profits will be subject only to the long-term capital gains rate, and if you make less than $200,000 per year, then you will pay at most 15% on the gain, and if you earn less than $100,000 and you are married filing jointly, then you can pay 0% on the gains. For people who are not married filing jointly, then the corresponding amount is a little more than $51,000.

Another way you can save on taxes and to reduce your fear of holding stocks is by buying stocks that pay a qualified dividend. You have to satisfy certain tax rules to enjoy the tax benefits, but if you do satisfy the tax rules, then the dividends are subject to the long-term capital gains rate, even if you did not hold the stock longer than 1 year. It is hard to get a better deal than that. (More information: Taxation of Investments)

Remember that stock prices do trend upward in time, but eventually it will decline for a certain period. There are 2 reasons for this. One, there's only so much money in the economy, and as more people invest, there will be less and less money that could be further invested in the market. The other reason is that because the economy gets stronger, people willingly take on more debt. This increases the money supply in the short run, but eventually the borrowers must repay the debt, which, in most cases, will mean that they must spend less. Many will also sell their stock to pay down their debt. Obviously, this has a depressing effect on the economy and on the stock market.

So if you invest for the long term, investing only money that you are not likely to need within your investment horizon, which is more likely if you have sufficient savings for emergency expenses, if you diversify your holdings, such as buying mutual funds or exchange traded funds or other means of diversification, and if you avoid using margin, then you could almost certainly make money in the stock market, with little risk.

Cover of The Pauper's Money Book

The Pauper's Money Book shows how anyone can manage their money to greatly increase their standard of living.