Investors use indicators to gauge the value and growth potential of an investment instrument. It can be anything that can help in predicting future financial value of a financial asset. While the concept is simple enough, it’s surprising that a number of investors don’t know the correct manner to use indicators to predict the trends.
In the context of financial investment, indicators can generally be grouped into two types: leading and lagging indicators.
Leading indicators are those that precede the price movements of a security. Examples of leading indicators include:
- Supply and Demand Zones
- Support and Resistance Levels
- Fibonacci Ratio Levels
The other type of indicator is the lagging indicator that follows price movements and includes:
- Income and wages,
- Productivity reports,
- Currency strength,
- Unemployment index,
- Interest rate,
- Balance of trade,
- Moving averages, and
- Bollinger Bands
When it comes to investing, relying on lagging indicators is not a good idea. Why?
The simple reason is that lagging indicators provide information about the past events. They don’t account for latest events that could affect the price trends. In other words, lagging indicators do not have predictive qualities similar to leading indicators.
While the past values can provide a sense of security and certainty to the investors, they do not serve as an accurate predictor of future price movements.
Remember that the price of a security is determined not by its past values, but its future income generating capabilities. Any changes in the fundamental factors that erode the profit potential of a particular security will result in decrease in the demand, and consequently the price of the security.
Since lagging indicators do not take account changes in the fundamental market factors, it cannot be relied as a correct gauge of future market values. They are great at indicating ‘was’ but not so great to define ‘is’ or ‘will be’.
Having said that, investors should not avoid looking at lagging indicators altogether when making investment decisions. I am not saying that lagging indicators are pointless. It’s just that they should not be used alone when making decisions regarding a particular security.
At the end of the day, my personal take on indicators is lagging and leading indicators can be used concurrently when making investment decisions. Investors that want to improve the business outcomes should focus more on forward looking indicators. The emerging field of predictive analysis is certainly exciting as they use data patterns and analysis to provide a clearer picture about the future price trends. We will touch on predictive analysis technique in more detail in future articles. So until then, you should stay tuned!