On Using Technical Analysis

There’s been a broad discussion in recent weeks about the efficacy of technical analysis in investment strategy (see here & here).  I’ve touched on this briefly in the past (see here), but my position is rather simple and I think it’s a position most people should adopt, because, obviously, you should adopt my views of the world!  Just kidding of course.  You’re free to do with my thoughts as you wish and I am only here to provide one guy’s perspective and not pretend to offer some holy grail view of the world.

Anyhow, much of the confusion on this discussion starts with definitions. Technical analysis often gets a bad rap for being labelled as charting.  But they’re two different, but related things.  Charting is the use of chart reading in various ways to formulate strategies.  Technical analysis, on the other hand, is simply the use of past data to analyze future market direction.  Now, a chart is merely a picture of past price action so charting is a subset of technical analysis, but does not comprise the universe of technical analysis – some of which can be extremely complex and sophisticated.

I find that understanding the past is an essential element in any good form of portfolio construction.  Perhaps you study the past to conclude that market timing is silly.  Or perhaps you study the past to conclude that buy and hold is silly.  But in the end, what most of us end up doing is essentially a branch of portfolio construction that begins with understanding past performance.  Of course, past performance is not indicative of future returns and while history rhymes, it rarely repeats perfectly.  So understanding past price performance and the history of price action is merely one building block in the development of a portfolio.  But that doesn’t mean it is a useless piece of the puzzle.  Whether you’re a trader or a buy and hold investor it’s useful to understand technical analysis and past price performance in order to better understand how one should go about attacking the future.

I am a very fundamentally driven analyst so I take the view that technical analysis is a good complement to good fundamental analysis, but to each his own. In my personal approach I like to apply an “asset-liability matching” methodology to asset allocation. For instance, if you need liquidity in the next 5 years you should hold instruments that have a high probability being there when you need them (bonds, cash, etc). If you have a much longer time horizon you can afford to wade into riskier assets that accrue cash flows over long time horizons. Within those assets allocations you can apply various forms of technically driven strategies (like trend following or momentum investing) that give you exposures to the proper asset classes assuming you apply them across the right time horizons and don’t day trade them, for instance. 

In sum, keep an open mind.  There’s no holy grail to the world of portfolio construction and understanding and embedding many different approaches into your own will only make you a more well-rounded and informed investor/saver.