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Lets take a look at Technical Analysis vs Fundamental Analysis and the pros and cons for each.
Which is the right approach for you though?
Someone using one approach will often dismiss the alternative but they both have their merits. Fundamental analysis is most useful for long term investments. Technical analysis is more useful for short term trading and market timing. These 2 approaches can be combined to formulate investments over a longer time frame.
Short term price movements are determined by supply and demand, which are affected by a lot more factors than a fundamental analyst would consider. For example, market sentiment and the effect of emotion on market activity can only be analysed using price action data. Charts cannot be used to determine whether a company is under or overvalued and what its value may be in the future. Charts reflect what has happened in the past, and their value diminishes the longer into the future you wish to analyse.
Analysing a companies financial and competitive position has several advantages as does analysing the environment in which it operates. When you focus solely on the business, rather than on the stock price, you gain a better understanding of what the true value of a company is.
This is vital for long term investing.
Decisions based on fundamental analysis may have a higher probability of being correct, especially when investing over a long time frame.
Fundamental analysis takes a lot of time and each company must be studied individually and in considerable detail.
The vast majority of information used in fundamental analysis is widely (and freely) available.
Fundamental analysis will not tell you what could happen to a share price in the short term, or the likely magnitude and volatility of a price movement.
Fundamental analysis is often thought of as an exact science but many assumptions are often made. For example, the discounted cash flow model is based on numerous assumptions which are rarely accurate. As the events of 2020 have proved, the fluctuations in share prices can be wild and the usefulness of target valuations is therefore limited.
A major advantage of technical analysis is that stocks, or any other asset type, can be analysed quickly. Automation is also possible for some forms of technical analysis, meaning you can scan the whole market in seconds. A technical analyst can therefore broaden their scope from a few stocks to all stocks, maybe futures, ETFs, interest rates and forex.
Technical analysis can be used to:
- identify price targets so you know when to take your profit
- identify price levels where your original thinking was wrong so you know when to take a loss
A technical analyst can therefore devise strategies with a clearly defined risk and reward profile.
Short term price action is affected by factors that fundamental analysis cannot discover. The effect of market sentiment, market psychology and supply and demand can all be observed by looking at a chart. Technical analysis can be used to improve trade timing, and to adopt trading strategies that are appropriate to current market conditions.
A technical analyst looking at a chart can quickly discover whether a stock price is trending up, down, or going nowhere.
Many strategies created using technical analysis can be tested on historical data:
- This means they can be tested to identify their potential profitability
- How they perform in different market conditions
- What their strengths and weaknesses are
Although many technical analysis strategies can be tested, some cannot. Many techniques have often been subjective and rely heavily on the judgement of the analyst. Technical analysis is often seen as an art instead of a science. With the advances in computing power this subjectivity is being reduced.
If you ask a room of technical analysts to review a stock you may well receive a number of different conclusions. A chart will appear considerably different if you alter the time frame (hourly, daily, weekly). There are an almost infinite number of analysis methods and indicators available, so forming a single view will be a challenge.
Depending on the technical analysis strategy adopted the win rate can vary from 30% to 70%, so risk management and position sizing is of vital importance.
Should I use Fundamental and Technical Analysis?
It is possible to use technical and fundamental analysis together.
A technical analyst looking at a price chart can get an idea of the trend direction. This can then determine whether the market agrees with a fundamental analyst and their valuation. This gives both analysts stronger signals to trade in a certain direction.
A fundamental analyst may identify a group of stocks that they wish to include in their portfolio based on their research. This group of stocks is then given to a technical analyst to decide when and if they should be bought.
A common approach to investment is called value investing. This means purchasing stocks that are undervalued (a fundamental analysts area of expertise) but have positive momentum (a technical analysts area of expertise).
Another strategy is investing in growth stocks. This means purchasing stocks that have high future growth prospects (a fundamental analysts area of expertise) but have experienced a large price correction (a technical analysts area of expertise).
A fundamental analyst may see a high stock price as a sign that a company is overvalued and therefore sell their stock. A technical analyst may disagree and decide to hold that stock until his analysis tells him otherwise. The reverse is also true with a fundamental analyst seeing a low stock price and wanting to buy stock. A technical analyst may decide to defer the purchase until a more favourable price.
Fundamental analysis can determine which phases of a business cycle are most profitable for a company, or group of companies. Technical analysis can then be used to confirm anticipated trends.
Fundamental Analysis vs Technical Analysis?
This site is predominantly aimed at technical analysts although we will not deter anyone from performing fundamental analysis to compliment their approach.
Trading AtoZ mainly resides on the technical analysis side but with a keen eye on the fundamentals.
One area this page has not touched on is Artificial Intelligence. Artificial intelligence has the potential to bring these 2 approaches closer than ever.