What is the difference between Technical Analysis and Fundamental Analysis
When looking to invest or become involved in the financial world, a thorough analysis of the move and flow of the market usually goes a long way in assuaging plaguing doubts. Naturally, picking out the right technique to analyse the situation of the market in due time is sometimes not exactly easy.
Now, be it computing a fundamental or a technical analysis, one is sure to come in handy when the need arises. However, they are both different school of thoughts.
A simple way of looking at a technical analysis would mean you would have to hone your power of predictions by taking a sweep at the previous market charts and past market predictions. Fundamental analysis could be basically described as employing mathematical methods in analysing how various economic and financial factors could influence the flow of the market.
While they both give an idea of the current and future state of the market, their differences become magnified over time. A detailed look into how each works should however tell us how they can be used together to achieve a common aim. Let’s go through them together.
Technical Analysis Vs Fundamental Analysis
The Technical Approach
A typical technical analysis begins the first approach with a survey of the market charts and stock prices of companies. Technical analysts basically rely on all information and data collected via thorough review of market charts. The charts and stock prices, according to the analysts, reveal all they need to know about the fundamentals of the company.
A swing at a simpler angle could be seen as when trying to analyse a person’s character via their appearance and comparing with their previous way of appearance and demeanour. The proportionality between the present and the past should be able to draft the behaviour that person.
Most technical analysts look through things this way. Technical analysis gives comprehensive trading models and rules which, according to Diffen, is based on the price and volume transformations.
Basically, there are players that would only buy securities in their uptrends while looking for a window (more like a short-term downward trend) for entry. They monitor these charts for all relevant price movements and narrow it down to the nearest zeroes within particular time frames.
Here, one of the major tools of trade is the addition of a moving average line to their chart to determine the overall trend direction. A moving average line basically tells us the average price of a security over a particular period of time. Naturally, an upward trend of the moving average and a price dip would prove a good entry point.
Well, I like to think of market volume as a typical lie detector for the market. You could tell the strength and future direction of a prevailing trend. Monitoring the volume tells analysts what they need to know.
Majorly, analysts use tools such as inter-market and intra-market price correlations, the patterns of the charts and stock market cycles to monitor volume transformations. These tools basically showcase the variation in price movements and trends while giving the analysts a ground for future predictions.
Focus on the Fundamentals
Fundamental Analysis, on the other hand, entails lots of paperwork, mathematical reviews and could be seen as the pragmatic part of investing. Fundamental analysts simply think, talk and view balance sheets, income statements and any other relevant financial records that would influence their conclusion.
This, of course, entails more than crunching numbers. This mode of analysis basically predicts future price movements by taking a deeper look at the fundamentals of the business or company. As such, monitoring the financial soundness of a company and its potentials before taking any step is made possible.
Taking a look at the simple analogy made about predicting a person’s future character. A fundamental analyst would not just take in the appearance and predict the person’s next move. The analyst would look deeply into what influences his behavioural attitudes at each point. He would pick out little movements and piece each together over time to discover what action would breed certain reactions.
Fundamental analysis, on this note, looks at a long line of investment decisions made over time, take in the values at each point in time and look for a basis for each factor that must have influenced the choices and values of investment.
Here, the analyst could look at the annual reports of sales recorded over time to understand the major direction and trend of revenues. An upward trend, of course, divulges a good entry point. However, a falling trend opens doors for further analysis.
A fundamental analyst would also look at the Earnings Per Share (EPS) and Price-to-Earnings ratio (P/E ratio) of the company to understand the effects of managerial decisions over time.
While the company might be raking in great revenues, retaining them is another storyline. The EPS usually tells a willing investor of the position of the margin. Naturally, a rising margin depicts a rising EPS.
The P/E ratios, however, tell a different story. P/E ratios are usually calculated based on the current stock price and the annual EPS. Unlike the EPS, the P/E ratios of companies do not show a direct relationship with the rising margin.
P/E ratio basically describes “cutting one’s cloth according a size that fits”. The P/E ratio of companies basically varies with each sector. For example, companies with high growth stocks like the tech companies mostly trade at higher ratios compared to stable lower growth companies. This, of course, is what analysts mean when they refer to the valuation of a company.
One of the primary factors that defines and sets each school of thought apart is their time frame. Looking at the approach taken by each analysis, it is safe to conclude that a technical analysis will take a shorter term approach when compared to the fundamental analysis.
This theory revolves round the fact that the analysis of the market with a technical approach would assume a timeframe of weeks or days or seconds. Technical analysts are mostly traders with the basic aim of selecting a stock or asset(s) that can be valued at a higher price in the short run. This works basically because they just have to look backwards to pick out relevant trends.
Fundamental analysis involves a longer time of analysis. This is basically because analysing the market means considering changes in data and financial statements that reflect the current state and future value. Fundamental analysts sometimes have to rely on quarterly financial statements which, of course, cannot be cumulated as fast as trading volumes appear.
Notably, a recognised tool of trade for fundamental analysts is investment. Getting to know where you’d put your money and time in, will mean you’d need time to go over every details you can get right? Thus, the time frame for fundamental analysis is quite long.
Chances of Co-existence
While these two methods of analyses are as different as day and night especially when applied to the valuation of securities, many investors and traders that had tried combining them had recorded success.
Their major rivalry mostly stems from the fact that value investors that belong to the fundamental school of thought would often assume that a security is being over-priced or mispriced over the short-term. Thus, they would conclude that the price will correct itself over long-run.
While these assertions are sometimes correct, investors have been known to lean towards both methods of analyses for better results. For example, a trader hoping to benefit from a breakout near an earnings report would look to the fundamental analyst for a review of the stock’s potentials.
Similarly, an investor, after identifying a significantly underpriced asset or security will look to a technical analyst to find the right entry and exit point before investing to avoid costly mistakes.
Though a combination of these two analyses sometimes looks good and is certainly beneficial, the idea is mostly not widely received by the uncompromising parties of each school of thoughts.