In this article we talk about the difference in approaches between fundamental and technical analysis
Let’s get a cup of coffee. And understand how to view the stocks. There are two broad themes based on which stocks are looked at.
Fundamental Analysis
Technical Analysis
We have many articles helping you to understand fundamental analysis at pvot. Let’s understand what technical analysis is and how it differs from fundamental analysis.
We should start with a graph to address this.
In simple words, technical analysis is reading the charts and making decisions based on the chart.
How can we read the chart? Is there any language to read the chart?
Every Stock chart tells us the story behind the senses, which captures everything into price/Volume action that we see on charts.
The answer is Yes & No at the same time. Yes, we have tools that help us to make certain reasonable decisions. However, it’s only right partially as we only reasonably can predict what will happen. Instead, we don’t have the exact language to say it unquestionably.
Let’s start with what the chart is. Say a farmer sells fish, he goes to the farmers market and sells the fish every day. Farmer, for ease, notes down the price of fish he sells for and makes the ledger entries. Now we have the data of the fish price every day many other things like demand and supply other fundamental factors like season, availability of tools to fish, etc. The price at which the farmers sell daily shows a trend according to underlying factors; moreover, plotting the same gives a chart that reasonably helps to predict the prices going forward.
“History Doesn’t Repeat Itself, but It Often Rhymes” – Mark Twain
Technical analysis is all about predicting future price movement with historical prices movement. An investor is always in a dilemma like Robert Frost to decide which road would lead him to success. Let’s comprehend the contrast between the two streets straightforwardly before choosing one:
Fundamental Analysis vs Technical Analysis
Fundamental Analysis is tied in with tracking down the fair value of stock and the difference between the value and the price at which the stock is trading in the market (margin of safety). If the value is lower than the current market price, then the stock is undervalued and is an ideal opportunity to purchase and the other way around. Investors get a margin of safety when they buy a stock trading below its intrinsic value.
However, In technical analysis is about understanding the patterns of the stock with the volume and the historical price movement to identify the supply and demand of the stock. Buy at the demand zone and sell when there is enough supply (resistance). One thing is common for both: the Law of Supply and Demand.
Investor understands its fundamentals via its management quality, industry, economic analysis, competitive analysis, valuation models, yields, and a lot more. Fundamental Analysis can be classified into two: a. Qualitative (brand, management, financial performance, moats, and other factors) and b. Quantitative (financial statement analysis, metrics).
In Technical Analysis, the investor uses certain technical tools, price action, trends and patterns to predict the price movement. Latter looks accessible to a new entrant as it doesn’t have much jargon to the former; however, it is not correct.
Effectiveness of Fundamental and Technical Analysis against time
Fundamental analysis is mostly preferred for the long term. Investor picks the right stock and invest systematically or in a lump sum and builds wealth over time. They expect the company to invest the capital effectively in their products or services and protect its return of capital from its competitors. Investors use a combination of these ratios to measure the return on capital of a company: Return on Assets (ROA), Return on Equity (ROE), and Return on Invested Capital (ROIC).
Technical analysis can be used as a short duration (trading function). TA focuses only on the previous data, whereas Fundamental Analysis focuses on past and present data.
Buy and Sell Decisions
Buy and Sell decisions for fundamental analysis are taken after knowing whether the stock is overvalued or undervalued through qualitative and quantitative approaches.
A trader may use support and resistance (demand and supply zone), trend lines, moving averages, momentum indicators, and others for technical analysis.
A person can do valuation of stocks only through the so-called Fundamental Analysis, and market sentiment is captured through Technical analysis.
Technical Analysts would have a Stop Loss, Target for each of the trades they execute, which mitigates them from the vulnerability in holding the stock for the long term. This sole reason pulls investors to trading. Fundamental Analysts believe in building wealth in the long run as equity markets are highly volatile, but technical analysts find an opportunity to earn through this instability.
“Rome was not built in a day, but Hiroshima and Nagasaki were destroyed in a day.” – Vijay Kedia
What is better – Fundamental or Technical analysis?
It’s in every case simple for somebody to anticipate the following day yet not one year from now. What’s more, individuals in the financial market are always worried about something (Ex: Depression, Recession, Inflation, and so on,) which at the same time makes investors worry about the stocks they hold. Consequently, they end up in short-term trading using technical analysis. And in technical analysis, people use various combinations of tools and indicators and add more day by day, leading to confusion and ending up in losses.
Fundamental analysis is vulnerable to misinterpretation and assumption of data like future growth prospects or cashflows. Fundamental Analysis is often wrong for a long time until we make money. Whereas in Technical analysis, we often get two signals which are contradictory (one indicator showing Buy and another showing Sell signal). Traders switch from the existing setup since they don’t discover productivity in one framework.
The more muddled it is, the more we lose. Fundamental Analysis and Technical Analysis have their pros & cons and an investor can benefit from the off chance that he realizes when to utilize what. Either for Fundamental Analysis or Technical Analysis, the setup should be to be easy to arrive at the objective “Return”.
Investors commit errors by purchasing the right stock at the wrong cost or own organizations they don’t know for long term whereas as a trader who uses technical analysis takes leverage and ends bankrupt. Both ought to be kept away from. Both fails to remember something typical: “Risk”.
“It is very simple to be happy, but it is very difficult to be simple.” – Rabindranath Tagore
What’s the road to success?
Technical analysis would give us a lot of opportunities in the short run and thus increases the number of buy/sell decisions we make, whereas long-term investing through fundamental analysis gives us a lesser chance to make effective decisions and accordingly builds the triumphant likelihood over the long run. It’s fitting for amateurs to have faith in long-term wealth creation.
“There will always be something to worry about in stock market, just own good companies and forget all about it.” PeterLynch – Fidelity Investments