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Subject 1. Principles, Assumptions, and Links to Investment Analysis PDF Download

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.

Learning Outcome Statements

a. explain principles and assumptions of technical analysis;

b. describe potential links between technical analysis and behavioral finance;

c. compare principles of technical analysis and fundamental analysis;

CFA® 2022 Level I Curriculum, Volume 6, Module 54

User Contributed Comments 26

User Comment
kalps Fundamental analysts (EMH believer) believe that markets react to changes almost immediately. Technical analysts believe that changes take time to be reflected and therefore prediction is possible.
kalps Fundamental analysts - look at accounting statements/ratios etc, however trechnical analysts look more at events (ex 9/11) and move to new equilibrium to make their move
hrai1 how about a techo-fundamental analyst?
katybo I think technical analysis is very useful if well combined with fundamental analysis.
katybo You donīt have to look for some special pattern, it will show up alone...and then you have an opportunity.
haarlemmer Afterall, whichever way we employ, we are making a guess. It is better to have more proof than less, although I am very technical.
haarlemmer My personal experience, as I have been in the markets for a while, is to have a watch list and when prices fall into certain range, I will build up my position. For certain markets, if you analysis really careful, you will find several good indicators.
sarath Persistence is assumed by the technical analyst...
viannie the market is a living being too! It is the results of interaction of market forces.
magicchip Markets are so irrational, that you adding to your position without regard to pattern would result in massive losses.
apiccion Technical analysts, not to be confused with techno analysts.
apiccion Right, because all humans possess the same level of ability to deduce meaningful conclusions. Futhermore, all humans can process unbounded amounts of data, and all data in the universe is always processed in a timely fashion.

If you believe the above paragraph, you need your head checked.
cong Similaries: both believe price is determined by demand/supply.
differences: gradual price adjustment /instant
use past data and non-economic data/ use economic data (accounting data)/irrational fator and rational factors rule in the long run
cong Technician do not take actions until a new price movement is under way.
SaeedAlam What formulae do fundamentalists use to calculate intrinsic value? Or is it subjective?
SaeedAlam Technical = Trends
Fundamental = Financial (statements)
jpducros very important notions often asked in CFA exams.
jpducros good tip SaeedAlam!
TiredHand Technical analysis is a crock of crap and we all know it. I am frankly shocked and appalled to see it get an entire Reading in the syllabus.
PeterL Totally agree with TiredHand. Might as well have a connect the dots question on the test.
johntan1979 Those who thinks technical analysis really works in reality will get burned, like I did :(

Doing due diligence, applying the proper valuation methods is the way to go.
sgossett86 It's good in really short term when you're taking fundamental analysis factors into consideration like upcoming earnings during your technical holding period and not holding over weekends since realistically valuation is independent day to day but trends can be jumped on when the market is right.

i made 7 grand (100%) in a month over about 15 trades holding overnight.

i also tried using technicals for fast cash but that's unrealistic. i lost thousands at that. half of that amount was given to me in bonuses from my job at amazon.
sgossett86 so basically if you approach it super conservatively and don't rely on it solely, plus the market indexes are stable money can be made skimming small amounts on a regular basis (1-1.5%/trade). With margin, it adds up..
irapp92 Humans love to find patterns, whether those patterns are useful or not is the question..
MathLoser Touch a hot cast-iron skillet once and you will remember it forever.
brer Technical analysis considers that the past evolution of prices/volumes/etc is not already incorporated in the current price.

Behavioral finance considers that among other factors the personal history of market participants will affect the cognitive process of market participants when making decisions
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