Fundamental vs. Technical Analysis: What Is the Difference?
The debate regarding the merits of fundamental vs. technical analysis is controversial. Traders and investors often miss out when they choose one over the other. Combining both stock analysis methods proves to be an effective route to take. Stock analysis is a key method that investors and traders use for researching and forecasting future trends in order to make more informed decisions.
Learn about the strengths and weaknesses of both analysis methods, the differences between the two, and how you can combine them to make profitable investment and trading decisions.
- Fundamental analysis examines the financial health of a business to measure the intrinsic stock value.
- Technical analysis looks for stock patterns and trends to forecast future stock prices.
- These analysis methods differ in their methodology, function, objective, and more.
- Both analysis methods are used to research and forecast future stock price trends.
What Is Fundamental Analysis?
Fundamental analysis looks at the financial health of the business that you are thinking of investing in to determine its intrinsic stock value. You can measure the value by looking at the basic economic factors that impact its value. Using the analysis, you can make decisions about what to buy and sell based on how the stock is currently trading. Factors considered in fundamental analysis include:
- Income, expenses, and revenue.
- Company growth prospects.
- Future competitive factors that the company may face.
- Expected industry market return on assets or equity.
The goal of fundamental analysis is to determine a value for the stock by considering the factors above. Since this methodology doesn’t include short-term pricing or trading swings, it is a long-term approach. Intrinsic value takes time to discern.
What Is Technical Analysis?
Technical analysis forecasts the price of a share based on supply and demand forces in the marketplace. Math and patterns drive technical analysis. Future stock market prices are forecast using past share performance statistics.
Technical analysts use the following factors to identify trades that will make a profit:
- Historical returns.
- Chart patterns.
- Price and volume behavior.
- Support and resistance levels.
Analysts and investors using technical analysis are convinced that future performance can be determined by analyzing and reviewing patterns from past performance data.
Differences Between Fundamental and Technical Analysis
The primary differences between technical and fundamental analysis are as follows:
- Meaning: Fundamental analysis involves evaluating a company’s stock to find its intrinsic value. Fundamental analysis also analyzes factors that could affect the stock’s future prices. Technical analysis, in comparison, is a static method that looks at patterns. It is based on the concept that patterns usually repeat themselves since investors typically behave in the same way when confronted with the same situation. Decisions made from the technical analysis are based on charts and price movement trends.
- Methodology: Fundamental analysis involves examining financial records, industry trends, economic outlook, and the performance of competitors. Technical analysis, on the other hand, examines market psychology and price movements.
- Function: The function of fundamental analysis is to make a good investment, while technical analysis is used for trading purposes.
- Timeline: Fundamental analysis is a long-term approach, whereas technical analysis is designed as a short-term approach.
- Concepts: Fundamental analysis uses return on equity (ROE) and return on assets (ROA). Technical analysis looks at price data and Dow theory.
- Gathering data: Analysts collect data primarily from financial statements for fundamental analysis, while they use charts to compile data for technical analysis.
- Objective: The goal of fundamental analysis is to find the intrinsic value of the stock. In comparison, the purpose of technical analysis is to find the right time to enter and exit the market based on past and current trends.
- Approach and vision: Fundamental analysis looks at the past and the future, while technical analysis only looks backward to make predictions.
Advantages and Disadvantages of Fundamental Analysis
As discussed, there is a definite benefit to both forms of analysis, but as with most things, there are pros and cons to consider.
Here are the advantages of using fundamental analysis to improve your investments:
- Understanding the bigger picture: Investors can determine the value of a business by looking at more than just the stock price. Factoring in movements in the economy and the industry helps investors determine the value of a company, which is key to long-term investment.
- A thorough understanding of the company: A comprehensive analysis gives the investor a better understanding of the business. They can familiarize themselves with the company’s revenue and what drives profit behind the scenes. The investor may also learn about the company’s shortfalls, which can help them better assess the risks of investing as well as the possible growth and income-oriented opportunities.
- Improved risk management: Since a fundamental analysis calculates the supply/demand ratio, an investor can better manage their portfolio.
- Easy access to information: The information fundamental analysts use is public, so it is relatively easy to gain access to it.
In comparison, here are the disadvantages:
- Inability to forecast short-term volatility: Fundamental analysis cannot be applied to short-term financial statements. This limits its usefulness in forecasting short-term volatility, price movements, and future value.
- It is not precise: Fundamental analysis is somewhat theoretical because of its long-term goals, so it is not as precise as other forms of research.
- Human instinct is not considered: Human instinct plays a role in the value of a stock, and this is hard to predict with fundamental analysis. In some cases, regardless of the business’s quarterly financial results, people may follow a ‘herd mentality’ and keep on buying.
Advantages and Disadvantages of Technical Analysis
Just like with fundamental analysis, technical analysis also comes with pros and cons.
Here are the advantages of using technical analysis to assess stocks:
- Speed: It doesn’t take long to analyze stocks, so technical analysis is a quick assessment. Certain tasks can be automated, which saves time and allows a technical analyst to draw information from a larger area.
- The ability to identify price targets: Identifying price targets can help you create investment strategies that show the risk versus the reward.
- The use of price charts: The price chart reflects all currently known information regarding an asset. A chart quickly tells a trader or investor if a stock price is in a trending or trading range. In the short-term, you can see the effects of market sentiment, supply and demand, and market psychology by looking at a chart. Technical analysis helps you choose the correct time and strategy according to market conditions.
On the other hand, here are some disadvantages to consider:
- Confusion: At times, one technical indicator will show a buy signal while another shows a sell signal, causing confusion. To avoid this problem, some traders combine technical indicators with patterns, moving averages, volume, and more to determine the entry and exit points.
- Inaccuracy: Forecasting stock prices using technical analysis is not 100% accurate. For example, a suggested entry or exit point for the stock is a suggested trade, not a guaranteed successful trade. After you buy a stock, entry stock prices may decrease, or after you exit, stock prices may rise.
- Different interpretation: Technical analysts do not always agree in their interpretation of stock values. Traders and analysts may interpret the same stock differently. Additionally, technical methods used to analyze stock may vary between analysts.
Combining Fundamental and Technical Analysis
Image via Flickr by kenteegardin
You can use both analysis methods to research and forecast future stock price trends. To get a better picture of the market, traders often combine fundamental and technical analysis. They use pricing models first, and then they look at charts to fine-tune their entries or confirm their assumptions. Alternatively, some traders review the charts first and then check the fundamentals, allowing them to determine whether future supply and demand are adequate enough to move prices through resistance or support in the longer term.
If you are investing in an unlisted company, it is especially vital to use fundamental analysis. However, it’s a good idea to use technical analysis as well — you can learn a lot about a listed company from their trading history. When you use these methods together, fundamental and technical analysis serve as highly effective tools that can help you assess your investments and succeed in the stock market.