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The world of investing can be a complicated one. With so many things to learn, it takes time and effort to gain the knowledge needed for successful investments.
A key aspect of investing is knowing the difference between fundamental analysis and technical analysis.
Both are methods for evaluating assets but are used in different ways. While fundamental analysis focuses on the actual assets, technical analysis focuses on price movements of an asset’s market value.
While both have their benefits, knowing the difference between fundamental analysis and technical analysis can help investors get started.
In this post, I will explain what you need to know about both types of analysis. You can then decide which one is best for you individually.
What is Fundamental Analysis
Fundamental analysis is a method that investors use to determine the true value of an asset by examining and studying its underlying factors, such as prospects of the company, management and economic situation, growth, balance sheet, management efficiency, industrial ratios, debts, financial health, earnings, financial indicators of a market, etc.
With fundamental analysis, investors attempt to measure an asset’s “intrinsic value “by analysing historical data and other factors. The term ‘intrinsic’ means that it is what assets are worth at their core.
The main objective of fundamental analysis is to determine if a company’s stock is undervalued or overvalued.
This can be useful for investors interested in holding onto an asset long-term that may last anywhere from several months to years.
They want to make sure they’re paying a fair price and not buying high and selling low (which makes them lose money).
Note: The goal of a fundamental analyst is to determine the true value of the company, its future growth rate, and whether or not that growth justifies its price.
An example of fundamental analysis is when you buy shares in X Company in the beverage (soft drink) sector, which means you are buying into its success.
The underlying factors that affect X Company would be consumer spending, its position within the soft drinks industry, costs of raw materials and other expenses, etc. These all directly affect its success or failure.
It means that you analyse the company’s performance, its financial results, and other factors like its management team to make an investment decision.
Analysts who do fundamental analysis will look for:
- Economy Analysis: In Economy Analysis, he will look at these factors:
- Gross Domestic Product
- India’s foreign exchange reserves
- Interest Rates
- Monsoon scenario.
- Industry Analysis: In Industry Analysis, he will look at these factors:
- Socio-demographic (social), and
- Company Analysis: In Company Analysis, he will look at these factors:
- Balance sheet analysis
- Cashflow analysis
- Profit/Loss Statements analysis
- Market history
- Company growth etc
What is Technical Analysis
Technical analysis is a method of forecasting the direction of prices through the study of past market data, primarily price and volume.
Technical analysis is based on the fact that history repeats itself.
The most commonly used technical tools include charts, trend lines, trading ranges, gap analysis, support/resistance, moving averages, channels, momentum oscillators, indicators, and volume.
In other words, the technical analysis identifies trends and trend reversal at an earlier stage to make a buy-sell decision.
Professional investment organisations use technical analysis when making buy/sell decisions about security and predict the future security price.
Technical analysts believe that all information about a particular stock is reflected already in the stock’s price. It’s reflected in the charts, i.e., graphs showing price over time.
They believe that stock prices have memory and tend to move in trends or large-scale ups and downs, which repeat themselves with a certain frequency.
Therefore, a technical analyst looks at the history of a stock’s trading pattern rather than external factors when forecasting future performance.
Technical analysts believe that price movements contain information that can be used to forecast future prices.
They don’t base their buy/sell decisions on company results or even rumours about them, but only on the charts (price and volume).
You could say that they don’t care what a stock is worth because their charts show them what it’s worth.
The most common form of technical analysis used by individuals is the candlestick chart, and it shows the day’s high, low, and closing and opening prices and the trading volume for each period.
The candlestick chart reflects the impact of investor psychology on a stock’s price and volume activity.
For example, the high-low range for the day is indicated by the real body size, which lies between the opening and closing prices.
The vertical distance between the opening price and the close reflects volume traded during that period or liquidity.
Technical analysts believe that volume reveals an increasing or decreasing level of aggressiveness in a price trend. Volume precedes price, i.e., volume tends to precede price and confirm the direction of a trend (up, down, or sideways).
The Difference Between Fundamental Analysis and Technical Analysis
The terms “fundamental analysis” and “technical analysis,” often used interchangeably, are very different.
They reach the same goal of forecasting future market movements but go about it in different ways.
The main difference between fundamental analysis and technical analysis are as follows:
- Fundamental Analysis is defined as understanding financial statements to determine the underlying value of the stock, while Technical Analysis focuses on analysing market activity, primarily through studying price trends and volume.
- Fundamental analysis is utilised by long-term investors, while technical analysis serves short-term traders.
- Fundamental analysis attempts to measure intrinsic value, but technical analysis has no intrinsic value measures. Intrinsic Value Definition: The actual worth of a stock or commodity, based on an underlying asset or group of assets, rather than the theoretical, perceived value.
- Fundamental Analysis looks at the causes of movements in stock prices, while Technical Analysis focuses on increasing or decreasing volume to predict future movements.
- A fundamental analyst will use earnings, cash flow, dividends, and valuation measures to determine the value of a stock. A technical analyst is more concerned with price and volume and how they affect future movements in securities prices.
- Fundamental analysis uses fundamental metrics such as Return on Equity (ROE), whereas technical analysis does not use ratios of any kind to ascertain whether a stock’s price is correctly valued or not.
- Fundamental analysis is an investment approach that uses financial ratios to assess a security’s value, while technical analysis is the practise of examining stock charts to determine which securities are trending and when to get in or get out of the market. Charts are used to spot price trends and patterns (e.g., head and shoulders, double top/bottom, etc.).
- Fundamental analysis is based on macroeconomics, the business environment, and financial conditions. Technical analysis is not concerned with these factors.
So we can say that when the two are combined, they can provide a complete picture of market activity.
The Benefits and Drawbacks of Technical Analysis
The benefits and drawbacks of technical analysis are as follows;
- It can be applied to any investment asset.
- Technical analysis provides detailed information about the market’s historical trends, such as prices, trading volume, and so on.
- It acts as an early guide to the market’s direction.
- It can not predict the long-term market direction with any degree of certainty.
- It needs constant updating because it does not provide reliable data for more than a few weeks, and the technical analysts must constantly update their analysis as new information becomes available.
- What worked in the past may not work again in the future
- The Benefits and Drawbacks of Fundamental Analysis
The Benefits and Drawbacks of Fundamental Analysis
- Fundamental analysis is usually the better choice in a long-term investment.
- Fundamental research can help us avoid risk by knowing the company, its financial statements, and how it makes money.
- Fundamental analysis only requires research and knowledge of a few strong factors, instead of many different indicators.
- Fundamental analysis is subjective by nature, and it is hard to find an undisputed truth in the data, making it difficult to make decisions when things do not go as planned.
- Fundamental research takes longer than technical analysis. Investors can not wait so long to see how their stocks fare before buying and selling them again, since there is more risk involved, and one might not be prepared for what might happen with their investments.
- People usually lack the time or patience needed for fundamental research.
In Your Decision-Making Process, Use Fundamental or Technical Analysis
In today’s investment world, there are two models for analysing a company.
The first is the fundamental model, and the second is the technical analysis model. Each model has its uses and limitations in making decisions about investments.
The point is to make good decisions on investing in a company, so it is important to understand all aspects and factors that one needs to consider.
I have discussed all these factors and their analysis above.
If your goal is to make a long-term investment, fundamental analysis is your choice. This model is based on the company’s financial performance, business plan, management teams, etc., that are required to increase or maintain its profitability in the future.
On the other hand, if you are thinking about short-term investments (days, weeks), technical analysis can help you make a decision.
Many investors also believe that by applying both methods together, investors can maximise returns while minimising risk.
Fundamental and technical analyses work differently for each type of trader and investor.
I would recommend testing each model on your own and using one or more to make sound investment decisions.
I hope that this article has helped clarify the difference between fundamental analysis and technical analysis.
Fundamental and technical analysis are both valid methods for making investment decisions.
The best decision-making method will depend on the investor’s personal preference, as well as their risk tolerance and time horizon.
If you have additional questions about either fundamental or technical analysis, please comment below!
Disclaimer: This article is for educational purposes only. It does not provide either personal or financial advice.