Everyone has their own opinion on which analysis techniques are better for picking stocks. The sad truth is, you need to have a basic understanding of both fundamental and technical analysis to become a successful investor.
Fundamental analysis is based on the quality of the underlying asset, and technical analysis looks more at general trends and overall market behaviour.
In this post I will explain what each form of analysis is, which tools you can use when performing each technique, and most importantly, how they can be effectively used together to boost your confidence when picking stocks.
What Is Fundamental Analysis?
Fundamental analysis is the method of using the stocks intrinsic value to see if it is worth buying the asset at that moment in time. While performing fundamental analysis you will examine a company’s economic and financial situation, and determine if it is likely to get better in the future.
Fundamental analysts study everything that can affect a stock’s value. Anything from the overall economy of the industry the stock trades in, to management structure and business model of the company.
The end goal of this analysis is to determine a number that an investor can compare with the stocks current price, to see if it is overvalued or undervalued. In other words, it is a way of finding the stocks fair value.
Fundamental analysis can also be applied to other markets such as forex trading, commodities, and options trading.
Pros & Cons of Fundamental Analysis
- Analysis based on a company’s financial and competitive position in the market allows the investor to gage if the company is likely to maintain its price.
- Focusing on the business rather than the share price means the investor has a better idea of the company’s actual worth.
- Portfolio risk can be managed better by calculating the premium to fair value ratio at which the stock is trading.
- The biggest profits are usually made when one investor is correct and the rest of the market is wrong, this can only be achieved through fundamental analysis of a company’s structure and management.
- Most of the data and information used in fundamental analysis is widely available.
- Fundamental analysis is time consuming as each company must be studied and evaluated.
- This is not a short term strategy, fundamental analysis does not take short term volatility into account, you must be a long term investor to use this.
- As much as fundamental is mostly calculation, it is an estimate and can be misleading for some companies.
- Valuation models used in this analysis are assumptions based on prior data and opinion, so you need to be responsible for your own figures.
What Is Technical Analysis?
Technical analysis is a trading strategy used to evaluate investments and identify trading opportunities. We do this by analysing statistical trends gathered from trading activity, such as price movement and volume of trades.
Unlike fundamental analysts, technical analysts don’t worry about the financial reports, sales, and earnings of companies. It focuses on the study of price and volume. Technical analysis tools determine the ways supply and demand for a security will affect changes in price.
Technical analysis is often used for short term investments or day trading. The various ways you can analyse a chart will offer signals to trade, such as a ‘level of resistance’, a technical analyst would use a level of resistance to provide a signal that the price will reverse. This can result in a large short term gain.
A technical analysis only takes into account historical trading data; it is very speculative, meaning just because something has happened before, does not mean it will happen again.
Pros & Cons of Technical Analysis
- The biggest advantage of technical analysis is the fact that stocks can be analysed quickly.
- Because technical analysis is mostly algorithmic signals, there are many softwares that can be used to show potential trade opportunities.
- This strategy can yield short term gains that would possibly take a fundamental analyst months to achieve.
- When trading options it allows for a lower risk margin as you can identify from historic data how much the price of a stock is likely to move.
- This is a speculative way to trade as it is a 50/50 chance that the price will move to where you want.
- Because you are not taking into account any fundamental factors you are not truly sure if the company will continue to rise or fall.
- This is not a science. Two technical analysts may have the opposite opinion on which way a stock will move, it’s up to you which one you side with.
- Technical trading setups have a lower win rate to those performed by fundamental analysts, the win rate of technical traders is often less than 60%.
The Key Differences
The difference between the two approaches is simple. It comes down to what determines a stock’s value and price. Fundamental analysis covers the company as a whole, understanding its profit, cash flow, and business model, ultimately coming to a fair value for the company. Fundamental analysts are concerned with the difference between the stocks trading price, and the value of the company based on their opinion.
On the other side of the track. Technical analysis is mostly focused on price action, which gives clues as to the stocks supply and demand dynamics, which will determine which way the stock is likely to move. Patterns often repeat themselves because investors often behave in the same manner during similar situations, giving the technical analyst an edge during volatile markets.
Tools Used For Analysis
Fundamental analysts look at a variety of ratios and metrics to determine a company’s value, these can be found on most major research sites such as Moringstart, Hargreaves Lansdown, or your brokerage account. You might also want to check out your chosen assets competition, so make sure to research the main rival of your company as well.
Another tool fundamental analysts use are management accounts. Profit and loss, balance sheet, and cash flow models are essential to gain knowledge of a company’s current situation, and the level of growth they have had in the past.
Technical analysts use mainly price charts which are most commonly in the candle stick or OCHL format, so they can see individual price points at certain times of the day. On most chart software you will be able to utilise moving averages, line tools, and fibonacci levels. I don’t personally use fibonacci levels, but moving averages help determine the general movement of the market, and line tools can help you identify levels of resistance.
Other price pattern software can be used but it usually comes at a high cost. I use SmartCharts as I was offered it as part of a course I did called Learn to Trade. I now pay $89 per month to use the software and I must say, it is worth it. But if you’re just starting out I suggest doing the analysis manually so you gain a better understanding. Also, if you can’t make an $89 profit each month, what’s the point of having the software to begin with.
Using Fundamental & Technical Analysis Together
I would recommend using both technical analysis and fundamental analysis together. This will give you a broad outlook on the market movement, as well as the in-depth financial knowledge of the company you plan on investing in.
Here are a few methods you can use to combine fundamental and technical analysis:
- Looking to see the general trend of a stock via chart analysis will give you a basic understanding of the broader markets opinion of the asset. Once you look into the financial documentation and ratios of the company, you will either have better confidence that the company will continue to grow, or you will gain fundamental knowledge that the company is overvalued, hence you would steer clear of the investment.
- You can build a watchlist of stocks you want to invest in through technical analysis. By briefly analysing charts and price movement, you can build an opinion of where the company is going next. You just need to confirm your assumption by looking at the future management plans and cash flows of the company.
- During volatile times in the market, such as during the ‘.com’ bubble, technical analysis can be used to find favourable entry levels for companies that are either growing, or looking to bounce back. Large corrections commonly occur, so using your fundamental knowledge of a company will help you determine at which price you want to enter into the investment.
- If a stock has been on an uptrend for a long period of time, it might mean it is overvalued. Using fundamental analysis you can estimate the company’s true value so you can evaluate whether you want to enter the trade.
- If a stock has reached an all time high, you might be appresenive to invest because technical analysis shows the price will come back down below the level of resistance. However, growth stocks regularly reach all time highs, you need to use fundamental analysis to determine whether it was a ‘false high’ created by ‘herd mentality’, or if the company is actually growing at a market rate.
- Finally, if a stock is trading close to its fair value, calculated through fundamental analysis, it is reasonable to assume that the price will move in a similar fashion to when the stock was valued at this price before. You can determine the ranges of which the stock moves by technical analysis of historic charts.
Long term investors generally look at both forms of analysis to arrive at an answer to whether they will invest or not. It is very important to have a basic understanding of both analytical techniques so you can avoid obvious mistakes when trading.
The risk with investing is high enough, you don’t need to increase your liability by not doing the proper research. Although the debate over which is better goes on, I think you should consider using both as much as you possibly can.
As fundamental analysis looks more to the future of a company, and technical analysis looks to the past for clue, you can get the best of past knowledge and future predictions by completing both before you risk your money.