Technical analysis involves the examination of past market data, such as prices and volume of trading, that leads to an estimate of future price trends and, therefore, investment decisions. Several assumptions lead to this view of price movements:

• The market value of any good or service is determined solely by the interaction of supply and demand.

• Supply and demand are governed by numerous rational and irrational (such as moods, guesses and opinions) factors. The market weighs all these factors continuously and automatically.

• The prices for individual securities and the overall value of the market tend to move in trends, which persist for appreciable lengths of time. That is, the new information enters the market over a period of time, leading to a gradual adjustment of stock prices.

• Prevailing trends change in reaction to shifts in the supply and demand relationship. These shifts can be detected sooner or later in the action of the market itself.

Technical Analysis and Behavioral Finance

Behavioral Finance studies why market participants make the decisions they do when interacting with the financial markets. Market participants, being humans (or algorithms programmed by humans), are influenced by cognitive biases, and those biases will tend to make them do things such as over-reacting to market information, or making errors such as taking profits early or holding on to losing positions.

Technical Analysis is the methodology used to measure these occurrences. Price patterns such as trends, volatility changes, bubbles and crashes will tend to repeat, as human nature remains largely the same over time. If a pattern that precedes a profitable outcome can be detected with a degree of probability using technical analysis, this information can be used to make returns from the market in the future.

Technical and Fundamental Analysis

Technical analysis and fundamental analysis are equally useful and valid, but they approach the market in different ways. Fundamental analysis involves making investment decisions based on examination of the economy, an industry, and company variables that lead to an estimate of value for an investment, which is then compared to the prevailing market price of the investment.

Although both types of analysis agree that the price of a security is determined by the interaction of supply and demand, technical analysts and fundamental analysts have different opinions on the influence of irrational factors. A technical analyst might expect the irrational influence to persist for some time, whereas other market analysts would expect only a short-run effect with rational beliefs prevailing over the long run.

A bigger difference exists between the two regarding the speed of adjustments of stock prices to changes in supply and demand. Technical analysts believe that new information comes to the market over a period of time because of different sources of information or because certain investors receive information or perceive fundamental changes earlier than others. Based on this belief, they expect stock prices to move in trends that persist for long periods, a gradual price adjustment reflecting the gradual flow of the information. Fundamental analysts, however, believe that new information comes to the market very quickly and they expect stock prices to change abruptly.

Technical analysts claim that their method is not heavily dependent on financial accounting statements, which have several major problems:

• Financial statements lack a great deal of information that security analysts need.
• Alternative accounting procedures can produce vastly different values for expenses, income, and return on assets. Comparing two firms in the same industry is sometimes problematic.
• Many psychological factors and other non-quantifiable variables do not appear in financial statements.

To summarize the differences:

• How do they make investment decisions?
  • Technical analysts make investment decisions by examining past market data to estimate future price trends. They identify new trends and take appropriate actions.
  • Fundamental analysts make investment decisions by examining the economy, the industry, and the company to estimate the intrinsic value of a stock. They then compare the intrinsic value to the prevailing market price and take actions.

• What data do they use?
  • Technical analysts use market data and nonquantifiable variables such as psychological factors.
  • Fundamental analysts use economic data (including accounting data, which is subject to management manipulation).

The usefulness of technical analysis is diminished by any constraints on the security being freely traded, by large outside manipulation of the market, and in illiquid markets.