When I started out as an analyst, I remember being introduced to the Wizard. He was a strange guy. Everyone else in the office did things I could understand. They were economists or analysts, they made spreadsheets, they tracked industries, they looked at numbers from the Bank of England or the government. But this guy played with wiggly lines and different coloured pencils and what looked like huge games of noughts and crosses. His office door said 'technical analysis' and what he did was charts.
Charts get a very bad press sometimes, partly because some investors use them as a short-cut for thinking. It's much easier to look at the wiggly lines and 'read the tealeaves' than it is to do your own analysis.
But there is a real philosophy behind technical analysis, and once you understand it, you see how using charts isn't nonsense - but it also has limitations and weaknesses that you need to understand. Technical analysis is about looking not at the value of the business behind the stock (fundamental analysis) but looking at the way that the market values, and trades, the stock (behavioural economics).
Behavioural economics looks at how a free market is affected by human behaviour, in the aggregate. For instance, we might observe a tendency for people to follow those stocks about which they see the most coverage in the newspapers, and to buy those stocks which are already rising, since they feel they are going with the flow. Behavioural economics explains the failure of efficient market theory (the theory that markets always perfectly reflect all information that is available about a given investment); by applying behavioural principles we can see why individuals and institutions make systemic errors. For instance, why the banks piled into sub-prime lending in 2005-7 and consequently needed bailing out.
Charts are simply one way by which we can assess the behaviour of the market. Rather than looking at the fundamentals of a stock - the company's business, its latest results, price-earning ratio, or balance sheet - we look at the way investors have behaved when trading that stock, as reflected in the movement of the stock price. So for instance we might notice that there is a typical trading range. That might reflect two possible views of the correct valuation, so the stock might swing between 'overvalued' and 'undervalued' points fairly regularly.
One particular factor that behavioural…
