Breaking with Tradition – Why I Don’t Use Technical Analysis: Part 2
He is king of the ant pile built on a foundation of quicksand. Human behavior is guided by enlightened self-interest. But people are notorious for altering their behavior when they are being observed and making decisions that to an outside observer seem to be against their best interest. This is why the scientific method (positivism) as it applies to the social sciences is an inherently flawed approach to studying behavior. And this is why, despite all of our desire, we cannot create a predictive model of the markets. Between our lack of perfect information about why we act and our range of responses to that imperfect information, the best we can do with our deductions is assign a probability of something happening.
Each person has a different set of priorities for assessing the value of an action or a thing, and we are not privy to them anymore than someone else is privy to why you decided on what to eat for dinner.
Price charts show only what people have done. They cannot tell us why they did what they did. A lot of financial writing seeks to discuss market movements in terms of human motivations. As there is no way of knowing why people do what they do, traders, necessarily, should not care about this at all if they want to be successful.
Reading Is Fundamental
As a trader, peoples’ motivations are not your concern; it is not strictly true to say that peoples’ motives for their actions are unknowable. You could, of course, call me up and ask me why I chose to have a steak for dinner last night and I could tell you. How that knowledge is useful to you is beyond me, but the point still stands. It is true in a practical sense. When considering the sheer magnitude of the market, though, it is irrelevant. So, it is important to ignore what we may think are the motivations of traders that compelled them to buy a stock as opposed to sell it. All we know is that they did and that will have to suffice for building any kind of trading system that has a hope of being successful. Analyzing our own motivations is hard enough; attempting to analyze the motivations of a couple thousand other people is beyond Herculean.
If technical analysis is ultimately a descriptive tool that can describe the past without much hope of commenting on the future, then fundamental analysis is the set of tools you use to consider the structural underpinnings of a market or stock. Fundamental analysis looks at how well the company is run by calculating metrics learned in MBA schools and the reasons why they are important. It also considers the macroeconomic conditions that the company is operating within, including political stability of the operating country, trends in input costs like commodities and labor, the costs of debt versus equity financing, access to public infrastructure and/or government contracts, and, most important, macroeconomic trends and local capital inflows.
Fundamental analysis is focused on research: data gathering and synthesis. It begins with asking questions, not looking at numbers. The most important question is “What information do I need?” Once armed with the right questions, you can set out to gather the information you need to reach a decision about a potential investment. If technical analysis is a snapshot of a moment in a company’s history, then fundamental analysis is the company’s story.