Should I use charts for Stock Investing?

Which Stock Investment Strategy to Use?

When you first start investing in the market, you must be wondering about all the different strategies that you can use to invest in stocks. Should you go the fundamental way and look at the financial statements in the annual reports, computing the PE ratios and try and determine whether a stock is undervalued? Or should you go the technical way; by looking at charts, and basing your buy and sell points on indicators such as the MACD, RSI, Bollinger bands and so forth? You have heard of success stories of great investors such as Warren Buffett, and Peter Lynch with the use of fundamental investing. On the other hand, I am sure you have also heard stories of traders making big bucks from intra-day trading (buying and selling a particular stock within the day). Both strategies are completely different but yet have success stories to back them up. So, which is the best?

Personal Experience

When I first started out about 2 years ago, I thought to myself: "If I can be really successful in technical analysis and make profits within a day or a week consistently, why not?" So there I went looking at charts and indicators on various stocks and try a find a good entry point to go into the market. I identified some and went in, based on a combination of MACD and RSIs. Also, I sold when the indicators told me that it was time to sell. On a whole, after a trial period of about 2 to 3 months, I made some gains and I made some losses but I learnt a greater lesson along the way. When I was looking at charts, I realized I never understood what these stocks essentially are. To me, it was just a ticker and a whole bunch of lines and bars on a screen which essentially gives me a "buy" or "sell" signal based on a set of indicators which may or may not be accurate. However, a stock is more than just a set of prices and charts.

What is a stock?

So what is a stock? A stock essentially gives you the right to own a stake in a company. When a company goes through an IPO, it splits up the ownership to its shareholders by issuing shares to the public. The company uses this money generated from the sale of shares to further spur its growth by investing in new growth opportunities in the market. As a result of this, profits will increase and therefore the value of the stock increases as well since the company is now worth more with the same number of shares. In a nutshell, this is what drives the price up in the long run.

Short Run Price Determinants

In the short run, stock prices are driven by many different factors. Examples include market sentiments, charts, and macroeconomic data. These factors are perceived differently by individuals and it is hard to predict where the stock is going in the short run because of this. Imagine trying to decipher the thought processes of the millions of investors in the market who are invested in the same stock as you are. People try and see it from charts, volume and momentum indicators etc but it is extremely difficult to achieve consistent profits from this strategy over a period of 1 year and longer.

Long Run Price Determinants

On the other hand, in the long run, stock prices are only determined by a single factor, and that is earnings. The more money the company makes for its shareholders, the higher the premium investors are willing to pay for them. Earnings are transparent as every listed company has to publish an annual report and quarterly statements to show how much the company is making or losing. Personally, I feel that this is a better gauge of a stock's performance and price in the long run as compared to trying to earn profits based on a set of assumptions or signals which may or may not be accurate.

Use Charts together with Fundamentals

However, I am not trying to tell you to throw away all your charting software or stop reading charts totally. Reading charts has its benefits as well. It will show you how much the price of a stock has changed over the course of the month or longer, and you can use it as a rough indicator to see which stocks are potentially undervalued at their current price as their PEs would have been lower. Similarly, when you see that the stock price of a certain company has risen up significantly higher than its direct competitors, it should prompt you to try and identify what are the fundamental factors that are driving this increase, and determine whether it is sustainable. Coupled with a fundamental investing approach, using charts by looking at price changes over a longer horizon, i.e. months or longer as compared to days or weeks, can help to assist you in the investment decision process by giving you an additional perspective of a stock's price compared to others in the market.

The morale of the story is: Do not base your investment decisions SOLELY on charts. Rather, use it as a complement with fundamental investing to give you an additional perspective to enhance the investment decision process. And remember: Ultimately, a stock's price is always determined by earnings. Never forget that.