Technical anaylsis vs fundamental analysis is an age old argument. But which is better? Or do they complement each other? Financial market analysis is often broken down into 2 broad categories, technical analysis and fundamental analysis. But what are the arguments for technical analysis versus fundamental analysis? What is the difference between technical analysis versus fundamental analysis? Which is the best technique to use? With this post, I will attempt to answer these questions and show you how you can apply each to your trading.
Fundamental Analysis
Fundamental analysis focuses on the intrinsic value of a financial instrument, in other words, what is the company worth. A financial instrument can be anything from stock in a company, a commodity, a currency, and interest rate or a market index. Investors that use fundamental analysis aim to buy instruments that are trading for less than intrinsic value and sell instruments trading for more than intrinsic value.
Fundamental analysis of an instrument is performed by examining the factors that affect the supply and demand for the instrument as well as the tangible and intangible values of the company’s assets. Those using fundamental analysis would generally be termed investors rather than traders. Fundamental analysts will place great weight on things such as:
- Earnings per share
- Price to earnings ratio
- PEG (price to earnings growth)ration
- Dividend yield
- Discounted cash flow
- Cash at bank
- Economic analysis and how that will affect the company
- Industry analysis
- Company management analysis
The main problem with fundamental analysis is that is assumes that the information available is disseminated perfectly and acted upon rationally. This is not always the case. For a great read on efficient markets you should check out A Random Walk Down Wall Street.
Technical Analysis
Technical analyst are not concerned with intrinsic value, they evaluate only the market activity such as price and volume. They use charts to identify patterns that can indicate the future direction. Technical analysis recognizes that there are forces that can affect the demand for a financial instrument that can cause it to deviate significantly from the intrinsic value of the underlying instrument. The most crucial elements of technical analysis are:
- Identifying the beginning of a trend
- Trading that trend
- Identifying the end of the trend
- Exiting / reversing the trade
Fundamental analysis is more widely accepted within the investing community while there are some critics of technical analysis. However, when used in conjunction, both methods can add value.
Happy Trading!
