When it comes to the stock market, there are two popular methods that are broadly used by investors and traders: fundamental analysis and technical analysis. While they are generally thought of as methods on opposite sides of the spectrum, both are used to research and forecast when to buy or sell investments. Each style of analysis has strong supporters and adversaries. In this article, we will dive deeper into understanding what fundamental and technical analysis are.
What is Fundamental Analysis?
Fundamental analysis focuses on evaluating the intrinsic value of a stock using data such as a company’s earnings, financial statements, company management, and economic and industry conditions. The goal of fundamental analysis is to gain insights into a company’s future growth potential and its underlying value.
Investors typically use fundamental analysis to make long-term investments, though short-term traders can also use this style to optimize returns. When investors analyze a company’s fundamentals, they may make assumptions about potential revenue and profitability using formulas and models, such as discounted cash flow (DCF) analysis, capital asset pricing model (CAPM), and ratio comparisons.
For example, if you want to purchase stocks in the technology industry to hold long-term, you can use fundamental analysis to determine what price to purchase the stocks at to get a fair value. There are also several macroeconomic and microeconomic factors to consider before making an investment.
Macroeconomic conditions: What is the current market sentiment surrounding the sector? Has there been any recent political or economic news that can affect this sector, such as inflation or regulations? How are companies in this industry performing? Do you believe there is potential for growth?
Microeconomic conditions: Is the company meeting its expected earnings? What are its assets to liabilities looking like? Is the current market price of the stock undervalued or overvalued?
By asking yourself these types of questions, you can then use this information to decide the true value of the stock.
What is Technical Analysis?
Unlike fundamental analysis, technical analysis focuses on statistical trends rather than the value of the assets. Technical analysts assume that the intrinsic value of a stock is already priced in so there is no need to look at the fundamentals. Instead, they use past price movement and trading volume of stocks to identify key patterns and trends.
Popular signals that technical analysts use to determine when to buy or sell stocks include support and resistance, candlesticks, MACD, moving average crossovers, and VWAP. These signals can be used to determine how a stock will act in the future. The goal is to forecast what the future market price of the stock will look like and set up strategies around your predictions.
Typically, technical analysis is used by short-term traders who are looking for quick profits. The style can be applied to many forms of high-speed trading beyond stocks, such as forex and options trading. Technical analysis focuses on how a particular investment normally behaves. For example, if a stock is trading below its recent price trend, a technical analyst may buy a position in anticipation of the stock price back going up in the near future. However, if the price is higher than the recent trend, that could mean the stock is overpriced and thus, could be an opportunity to short the stock.
Why are Fundamental and Technical Analysis Important?
If you want to invest and trade, you need to have some criteria in place to evaluate the assets you are interested in and predict what their future prices may look like. The stock market is constantly changing, so you need to create data-backed trading strategies that help you profit. Knowing common trade terms is a must!
Fundamental analysis and technical analysis are two types of methodologies that investors and traders use to make rational investment decisions. Whether you are a fundamental analyst or a technical analyst (or both), understanding how to use these methods will allow you to make profitable buy and sell decisions.
While fundamental analysis and technical analysis are the two most popular styles of analysis used by investors and traders, their approaches towards the market are very different.
Fundamental analysts focus primarily on financial data, overall industry trends, and the economic outlook of both the market and the underlying security. They use a mix of both present and past data to determine the intrinsic value of a stock.
Technical analysts focus primarily on price movements and market psychology. They use past data of charts and indicators to predict how the future price of a stock will look.
Fundamental analysts typically make long-term investment decisions. They take the time to understand the value of their assets and take a deep dive into a company’s financial data before buying a position in the stock.
Technical traders take a short-term approach to their investing decisions. Most of the time, they do not care about the underlying value of the company and may not know anything about the stocks they are taking a position in. They just look for the right entry and exit points and build their strategy from there.
Generally, fundamental analysis is used for investing while technical analysis is used for trading. Sometimes people may use investing and trading interchangeably, however, they are not the same. Investing has a long time horizon while trading has a relatively short time horizon. Investors may buy and hold an asset for years before selling, while traders may be in and out of a position in minutes.
Form of Data
Fundamental analysts use economic reports, political and economic news, industry statistics, and company financials to make investing decisions. They use metrics such as earnings per share (EPS), price-to-earnings ratio (P/E ratio), return on equity (ROE), return on assets (ROA), and book value per share.
Technical traders use chart analysis to analyze the future price of a stock. They use metrics such as trading volume, support and resistance levels, relative strength index (RSI), moving averages (MA), and chart patterns.
The main goal of fundamental analysis is to determine the intrinsic value of an asset while the main goal of technical analysis is to determine the right entry and exit points for a stock based on historical charts and patterns.
Advantages and Disadvantages
Just like with most things, fundamental vs technical analysis have their own advantages and disadvantages that make them more attractive to different people.
Fundamental analysis uses analytical methods that are backed by financial data. The method takes a holistic approach to invest by focusing on both microeconomic and macroeconomic conditions. Analysts who use this method can eliminate personal bias by looking at past and present data and using both statistical and analytical tools to make investing decisions.
By taking a 360-degree approach, investors can gain a better understanding of everything that is happening in a company, the industry, and the overall market. Taking a deeper dive into the fundamentals also allows investors to discover trading opportunities that other people may not notice.
For investors with a long time horizon, using fundamental analysis is ideal. Knowing the intrinsic value of a company gives you confidence in your investment decision. You know the value of the security and its potential returns before you take a position.
Fundamental analysis is time-consuming and overwhelming at times. It takes a lot of effort and research to carry out industry and market analysis and financial modeling. Sometimes fundamental analysts may experience information overload because they are analyzing many different moving factors that can influence the future price of a stock.
This method is also very subjective and requires making assumptions about the future financials of a company. Fundamental analysts can make different conclusions about the same asset using the same data based on how they interpret the information. Unexpected changes in the economy or political scene can also lead to problems in the analysis.
As mentioned before, fundamental analysis is less useful for short-term traders who are looking to get in and out of a position quickly.
Technical analysis uses volume trend, which gives you insights into the supply and demand of a stock. By looking at volume, you can gauge what the current market sentiment is and thus when the price may go up or down.
With technical analysis, you have similar information that other retail traders do in terms of being able to see the current market price and all the charts and trends. You can also use patterns to your advantage by analyzing when a stock usually goes up or down in price. This can help you decide when to make your entry and exit positions quickly and rationally so you can take profits.
Technical analysis is most useful for day traders or swing traders who are looking for quick profits. You do not need to conduct any research about the company’s financials or economic conditions. All you need are charting tools to determine your trade decisions.
Because you are relying on patterns and indicators to make your trading decisions, sometimes the indicators may produce conflicting signals. Technical analysis also completely ignores the fundamentals of the underlying assets, which can cause you to miss red flags when determining when to exit and may be risky for long-term holds.
Sometimes traders also face analysis paralysis because they are using so many different technical tools simultaneously. If you are bombarded with too much technical information, it can be hard to determine which factors are the most important.
Technical analysis also assumes that the market and traders make rational decisions. However, unexpected circumstances in the political, economic, or social sphere can lead to price changes that divert from historical data. Because this method focuses on past data, there is no guarantee that you will be 100% accurate about your predictions.
With technical analysis, you are competing against hedge funds and professional traders who may have complex algorithms that work faster than you. The strategies behind technical analysis may also be overwhelming and intimidating for beginners.
Which Method is Best For You?
To determine whether fundamental analysis or technical analysis is best for you, you need to decide how you want to invest. Are you looking for long-term or short-term investments? Do you want to be a day trader, swing trader, or long-term investor? How much risk are you willing to take? How much effort do you want to put into investing? Understanding what you are trying to get out of investing will help you decide if you should be a fundamental or technical analyst or both.
Can Investors Use Both Methods?
While both methods have staunch supporters and opposers, you can use both styles simultaneously. Currently, I take a hybrid approach. For investments I plan on holding for at least a year, I use fundamental analysis to better understand the intrinsic value of the asset. For stocks and options I plan on holding for a day or a few weeks, I use technical analysis to determine when to enter and exit my position. Sometimes, I also use technical analysis for long-term investments to find buying opportunities when prices dip. Though some people may stick to only one method, you do not have to. Depending on what your goals are, you can use both styles of analysis to your advantage.
There is no right or wrong way to approach investing. Both methodologies are used by traders and investors to make investment decisions. What you decide to use is ultimately up to you. If you are a beginner, try using both methods to figure out your trading style, preferred trading time frame, and financial goals. At the end of the day, what is most important is figuring out a trading strategy that works best for you.