- Technical analysis examines factors, primarily relating to demand and supply of a security, with the sole aim to time the investment decision.
- It helps to determine support and resistance levels on the price chart, which eventually helps in making an exit plan.
- Technical analysis can make the whole process of investing an objective one.
Portfolio building is a process of selecting securities optimally with the sole aim to achieve maximum returns while taking minimum risk. A well-made portfolio consists of diversified securities such as stocks, bonds, money market instruments, etc. to reduce the overall risk.
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To plan for the portfolio investment, an investor must have an in-depth knowledge of either fundamental analysis or technical analysis (knowledge of both is always better). Fundamental analysis helps to gauge a long-term view of the underlying security, primarily by interpreting factors such as the earnings capability of a company, management quality etc. These factors decide whether the stock is worthy of an investment or not.
On the other hand, technical analysis analyses other factors, primarily concerning to demand and supply of a security, with the sole aim to time the investment decision. On that note, let us have a brief look at what all technical analysis does to build a better portfolio.
- Helps to manage risk
Technical analysis is the only form of analysis which helps to determine exits out of an investment even before the money is on the line. This is one major drawback of fundamental analysis, that fails to gauge the exit level in case things go wrong. The only time it calls for an exit is either when the company becomes fairly valued or stops performing well. In the latter case, it may be too late to exit as the performance is revealed only after a quarter, at the minimum.
As a popular saying goes in the stock market, the only difference between gamble and investing is how you manage your risk. Anything can go wrong anytime, therefore it is imperative to have an exit plan well before placing your bet. Technical analysis helps to determine support and resistance levels on the price chart which eventually helps in making an exit plan.
- Timing the securities
Rightly timing your investment decisions could become the difference between a winning and a losing portfolio. Generating alpha in the stock market is difficult without appropriate timing of when to enter, exit, reduce or add on an existing position.
Technical analysis helps to time the market, primarily by looking at price charts and various technical indicators making for a meaningful analysis. For example, when a stock gives a breakout above a major resistance level, it could be an ideal time to enter for a quick gain as the stock generally stays in momentum for a while after a major breakout. This is a better approach than buying the same stock and sitting on the position for a long time, before the stock actually starts to move.
- Intermarket Analysis
Technical analysis has popularly been used to perform intermarket analysis. An intermarket analysis is essentially analysing two or more different markets having a correlation with each other, whether direct or inverse. This helps to analyse a market based on its correlated market, helping to further confirm the direction of the market primarily being analysed.
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For example, gold and equities market generally have an inverse correlation as when investors perceive a risky road ahead for equities, they tend to pull their cash from stock market to put it in safe-haven such as gold. Therefore, if equities market seems to be set for a major correction, an analysis of gold (for an uptrend) could further confirm the downtrend in equities market.
- Removes ambiguity in decision making
Technical analysis can make the whole process of investing an objective one. One of the major issues faced by investors is the subjectivity of the data they use for analysis, which is very common while doing fundamental analysis. For example, if the P/E ratio of a company is low it simple means that the company is trading at a lower valuation with respect to its earnings.
Now this could be a good sign as everyone wants to buy low and sell high. However, it also casts a doubt on why the market is pricing the company at this lower valuation when its peers are commanding a good premium – one reason could be an uncertain future, which poses a risk even for buying at a low price.
This ambiguity creates confusion and often leads to inconsistent results from investments. Technical analysis can make the whole process of selecting securities totally objective.