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Technically speaking
Should I use technical analysis of the market when making my trading decisions?
March 11, 2005: 12:48 PM EST
By Walter Updegrave, CNN/Money contributing columnist

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More information on Updegrave's new book.

NEW YORK (CNN/Money) - How reliable is technical analysis as a dependable measure for selecting entry and selling points in a given market?

-- Dan Hellie, Duluth, Minnesota

I see the debate over the reliability of technical analysis as an investment strategy much the same way I see the debate over the value of active stock-picking vs. buying passive indexes -- an lively and sometimes interesting discussion that will never be settled definitively either way.

Proponents of the practice will point to all sorts of examples of how various ways of massaging price and volume data on stocks leads to clear insights to the future path of stock prices, not to mention tidy profits. And critics of the practice will say technical analysis is the investing equivalent of voodoo and point to just as many instances when technical analysis came up short.

Another way to evaluate the market

However you may feel about this practice, however, this much is clear: for better or worse, many, if not most, brokerage and research firms use technical analysis of some sort when evaluating the overall market and specific stocks.

For those of you who aren't familiar with technical analysis, here's a quick look at how it works.

Unlike fundamental analysis, which evaluates a stock based on factors such as a company's earnings and book value relative to its price, technical analysis looks for clues for buying or selling opportunities based on patterns in a stock's trading price and sales volume.

The idea is that the patterns result from large institutional investors moving money in and out of particular stocks and the market and thus provide insights into how investors feel about the prospects for individual stocks, indexes or particular sectors of the market.

In search of such meaningful patterns, a technical analyst might create, say, a chart plotting a company's stock price, or an index such as the Dow or the Standard & Poor's 500, against a 50-, 100- or 200-day moving average of the stock or index. It's generally a good sign if a stock or index is breaking through or trading above that moving average and a bad sign if it's crashing through or trading below that moving average (although, in fairness to technical analysts, I should add that I'm grossly oversimplifying here.)

Technical analysts also look at the volume of trading for confirmation of a trend. The expression "volume reinforces the trend" means that an upward swing in share prices that occurs while trading volume is rising is more likely to continue than one that occurs while the number of shares traded is on the wane.

Brokers use it -- but should you bother?

The real question as far as individual investors are concerned is whether they need to be incorporating this type of analysis into their investing strategy.

My take is this: If you're a long-term investor, I don't see any compelling reason to look for confirmation of a particular stock's prospects in its short-term price movements.

And I see even less reason to look to short-term patterns and trends as a rationale for whether you should be in the market or not. Setting and maintaining an appropriate mix of stocks and bonds is a much more effective way to manage the long-term risks and rewards of investing.

If you're a short-term investor -- that is, someone who likes to jump in and out of different stocks or the market overall in hopes of making quick gains -- well, I suppose that technical analysis might be useful in conjunction with good old fashioned fundamental analysis.

I should add, though, that I believe darting in and out of different investments for short-term gains is for the most part a losing proposition, because of the costs involved and the potential for buying and selling at the wrong time. But if you're going to play that game, then I suppose you want to know what others of your ilk are doing.

If you want to learn more about technical analysis -- either out of idle curiosity or because you think it might be helpful -- there are a number of sites you can go to including StockCharts.com and StreetAuthority.com.

And if you'd like to do some charting yourself for individual stocks or indexes, you can check out the interactive charting section of BigCharts.com.

Who knows, maybe you'll find the Holy Grail that technical analysts have been looking for: a pattern that's virtually 100 percent accurate yet at the same time surfaces early enough so investors can get in while there are still big gains to be made. But don't hold your breath.

Walter Updegrave is a senior editor at MONEY Magazine and is the author of "We're Not in Kansas Anymore: Strategies for Retiring Rich in a Totally Changed World."  Top of page

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