Updated: Sep 21, 2020
One of the age-old debates in financial market theory, there are two competing philosophies and leading schools of thought: the choice between Fundamental Analysis and Technical Analysis. While both methods are intended to help investors conduct research and predict the future price of a specific asset, they differ from each other the application and tools they used.
Fundamental advocates estimate the intrinsic value of an asset by focusing on data from market and industry research, official statistics and company financial statements. They use both the data in the macro level (e.g. global, country, market and industry specific information e.g. economic indicators, GDP, employment, inflation, interest rates etc.) and data in the micro level (company specific information e.g. financial statements, announcements etc.) to screen good markets, industry sectors and individual companies for opportunities. These procedures have their respective pros and cons, and it is advisable to combine bot macro and micro evaluation for fuller and more accurate projection. The company’s business model, management, leadership and corporate governance are also evaluated in screening process. Following the screening , fundamental analysers use a pricing model to forecast the actual value of the stock price, its intrinsic value. They base their analysis on three assumptions that current price from stock market often does not fully reflect a value of the company supported by the publicly available data, the value reflected from company's fundamental data is more likely to be closer to a true value of the stock and that in the long run, stock market will reflect fundamentals.
Technical Analysis promoters emphasize only on asset’s current trading volume and its price, using charts and price patterns formed by the stock price and trading volume, which is interpreted as signals to enter (buy) and exit (sell). They assume that data needed to make projections are already factored into the asset’s price and sue forecasting tools like support and resistance, trend-lines, momentum based indicators , candlesticks and others.
Traditionally, longer term investors and position traders prefer fundamental analysis as primary approach while shorter term traders and speculators use technical analysis to give quick forecasts on price movements. Others try to combine both approaches to make a more balanced and accurate evaluation for investment opportunities.
Disadvantages of Fundamental Analysis include the scenarios of abnormal market conditions where market behaviour and sentiments are sufficiently large that they overcome the effects of intrinsic value calculations. Also, there is some degree in subjectivity such that the projected growth of company returns for next few years and safety margin need to be estimated based on risk appetite of analyst.
Shortcomings of Technical Analysis include that these charts reflect past performance, which may not reflect future price actions. The many indicators also may cause confusion such that they may give conflicting signals that may delay the investment decisions. The interpretation of chart patterns may also be very subjective.
It is advisable to combine both Fundamental and Technical analysis approaches of asset evaluation by the following proposals:
For long term investments, first use fundamental analysis to conduct market and industry screening. Then proceed with investments in either broad market or sector funds. Minimal technical analysis is used, perhaps just to confirm the long term (yearly or multi-yearly trend-lines) trends, after the investment decision is made.
For medium term investments, first use macroeconomic and organizational indicators to conduct market, industry and stock screening, then estimate intrinsic valuation to verify if the stock is indeed undervalued. Subsequently, use medium time frame technical analysis (weekly and monthly chart patterns, candlesticks) to time the investment transactions.
For shorter term trading, first use technical analysis in short time frame (intra-day), hours or minutes) to determine the price fluctuations and trading volume, and then use macroeconomic indicators and company news to confirm investment.