The biggest mistake that almost everyone makes with investing is that they try to "follow the trend". Whether you call it technical analysis or just investing in whatever "looks good", this investment strategy is almost certain to leave you broke...eventually.

Even if you are successful at using technical analysis, I'm willing to bet that you either 1) don't take long positions and; 2) haven't been investing this way for more than 10 years with a net gain to show for it.

What is technical analysis?

Technical analysis is a method of investing in the stock market by relying on data mining, studying charts and past performance of the stock market. It is widely used today with a dubious record of success.

Technical analysts believe that the historical performance of stocks and markets are indications of future performance; that past performance is indicative of future returns, and that studying charts and past performance is the "tool" to see which patterns we should buy into. All we need to do is find the "right" pattern and trade on that pattern. The returns in financial markets are already there, and will be there in the future (hence the idea that we can trade on a specific pattern or patterns). All we need to do is capitalize on them.

Debunking Technical Analysis

Technical analysis ignores the fact that there must be a cause and effect relationship. Companies do not exist in a vacuum or arbitrarily, and neither does the pricing of its stock.

Technical analysts believe that each individual investor somehow comes up with their own price. Whatever they think the price of the stock should be is the "right" price - is what the stock is worth. Because everyone will value the same stock a little bit differently, the company is valued differently by every investor, and thus the company has multiple values according to the number of individuals investing in that particular company. Ultimately, the stock's price is decided, they believe, by the market, but that the decision is arrived at subjectively - based on the opinions of individuals.

In other words - you are supposed to find a "good looking" stock and invest in that stock. How do you know what constitutes a "good looking" stock? Well, you buy what everyone else is buying. How do you make money? Well, by buying what everyone else is buying you follow (and become part of) a trend. If the trend is up, you make money, if the trend is down, you lose money. The skill then, they say, is finding the "right" trend and riding it to profits.

In actuality, you are doing little more than what amounts to guessing. If enough people get together to buy the same stock and they are all guessing the same thing, does this make their pick "valid" or "right"? Absolutely not, but technical analysis would say that the trend is what matters, not whether the traders and investors are "right" or "wrong". After all, it is subjective.

What this method of trading does is encourage trading on [long-term] patterns, or alleged patterns in the stock market. But no such long-term patterns exist. It is impossible for these patterns to exist because the assumptions or patterns are based on a relative organization of factual data, but are not in any way predictive. If technical analysis could be followed consistently, there would be relatively little risk in financial markets.

Very short-term patterns in financial markets do exist however, and this is the very reason why technical analysis and the resulting long-term "patterns" they espouse cannot ever exist. These short-term patterns give the illusion that technical analysis is a valid way to invest in the stock market. However, there is a very reasonable explanation for these short-term patterns and why they exist and why they disappear very quickly.

Very intelligent traders, with a lot of ability and a lot of skill enter into the financial markets looking for patterns that develop from natural phenomena, they trade on these patterns, exploit them, and subsequently eliminate them from the market.

This "method" of trading gives us absolutely no answers, only questions which cannot be answered because they are unanswerable. Not because we are not intelligent enough to understand the reasoning behind it, but because there is no reasoning behind it.