Saturday, March 17, 2012

Charts as Predictors

I am not big on using charts, graphs, etc.  They are useful in telling us what has happened in the past, but I am not particularly fond of charts and patterns for predicting the future.

There are a lot of people out there who use charts and trends to make predictions on investments.  They will talk about head and shoulder patterns or breaking above a 200-day moving average or some other jargon.  They base their analysis of an investment primarily using these charts and trends.  While I often find it fascinating, I also think it is mostly bogus.

If there is one thing you should learn from Austrian school economics, it is that economics is really a study of human action.  Everything in economics depends on human action.  And that is really the problem with charts and graphs.

You could read some analyst who says that gold is about to break out because of a particular trend line on his gold chart.  But why should this mean anything for the future?  What happens if Bernanke comes out tomorrow and announces that the Fed will not engage in any more quantitative easing (money creation) for as long as he is Fed chairman?  The gold chart can't possibly know any of this.  If it did, then the chart would already reflect this and the price would have gone way down, assuming that people believed what he said.  How can the chart know what millions of individuals are going to do the next day and whether they are going to buy or sell or hold or do nothing?

Again, charts and graphs can give us a good overview of what has happened in the past.  Perhaps this can contribute to our decision on whether or not to invest in that particular thing.  But charts can't predict the future any more than a Magic 8 Ball.

When I read some analyst who says something along the lines of, "this stock's 6-month chart shows that it is about to break out and will probably double in price over the next few months", I wonder many things.  First, if this is such a great tip with a high, practically-guaranteed, rate of return, why is this person sharing the information with everyone else?  Second, if this person is so good at doubling his money every few months, why doesn't he have wealth in the neighborhood of Warren Buffett or Bill Gates?  Third, why doesn't he list all of his previous calls and tell us what the results were of his recommendations?

Charts can be somewhat useful and informative, but they can't predict the future.  They can't predict human action.  If anyone is selling you an investment solely based on the use of a chart or graph, my recommendation is to walk away from that person.

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