Fundamental Vs. Technical Analysis: Which Approach Is Right For You?

Investing

Fundamental Vs. Technical Analysis: Which Approach Is Right For You?

We explain the difference between fundamental and technical analysis, and discuss how to determine which investing approach is best for you.

Written by BC Low on 18 April 2018

From January 2012 to September 2014, crude oil was trading between US$90 and US$110 a barrel. In October 2014, a signal from a long-term chart showed that it was headed for a major decline. It was hard even for a seasoned chartist to believe that oil price was falling in big way. The fundamentals could not explain it, but the technicals were clear.

Subsequently, oil price took a tumble and Nymex Light Crude fell all the way to US$26.05 in February 2016. The oil and gas sector went into a long winter that lasts till today. This illustrates the power of market forecasting, the realm in which fundamental and technical analyses reside.

But what exactly are fundamental analysis and technical analysis? How do they work, and which is the right approach for you as an investor?

What is fundamental analysis?

Fundamental Analysis, Technical Analysis

Fundamental analysis is a method of evaluating a security to measure its intrinsic value, by examining related economic, financial, and other qualitative and quantitative factors.

For stocks and equity, fundamental analysis uses revenues, earnings, future growth, return on equity, profit margins, and other data to determine a company’s underlying value.

The end-goal of fundamental analysis is to enable an investor to arrive at a conclusion as to whether the security is under- or over-valued. With that, the investor then proceeds to either buy, sell, or hold the security.

For currencies and commodities, fundamental analysis focuses on economics, trade data, and supply and demand as the basis for identifying strength or weakness in the market.

In essence, fundamental analysis uses the logic behind markets – reasons that have moved a market – to provide a rationale for its future direction. This is its appeal, even though reasons which account for past events may not decide the future.

Fundamental analysis tends to be based on mid- to long-term factors such as interest rates, industry outlook, international trade balances and so on. Fundamental factors, however, cannot explain short term fluctuations that befall markets, and therefore cannot apply in day-to-day or intra-day trading.

What is technical analysis?

Fundamental Analysis, Technical Analysis

Technical analysis has its origins more than a century ago when Charles Dow (of Dow-Jones Industrial Average fame) wrote about markets in The Wall Street Journal. His writings came to be known as Dow Theory, and formed the basis for technical analysis. One of his most important dictums was that markets move in trends.

Technical analysis forecasts a financial instrument’s future direction by analysing price action and other technical tools. It is based on two assumptions: first, that the price of a security at any given point in time accurately reflects all available information, and therefore represents the true and fair value of a security.

The second assumption is that price is not random, that markets move in trends, both in the short- and long-term. This implies that investors and traders can profit from trends found in markets.

In essence, technical analysis is based on the premise that markets have trends and unlike fundamental analysis, the reasons for market movements do not matter. The advantage of technical analysis is that it can be applied in all traded markets using the same tools.

Traditionally, technical analysis has been associated with short-term trading. The reason is the overuse of the daily chart by practitioners. Daily charts track price action for one trading day.

In recent times, with the advent of real-time markets, charts are used for intra-day price movements, and technical analysis is utilised for even shorter term trading. This further reinforces the belief that technical analysis is only good for short-term trading.

In fact, with computerisation, it has become possible to apply technical tools to larger time frames, generating weekly and monthly charts.

It is now possible for technical analysis to be re-oriented for the longer term for investors, based on weekly and monthly charts. This is a newer phase in technical analysis, which has yet to be adequately explored.

Choosing the right approach for you

It is worth noting that both fundamental and technical analysis can work, but both can also fail. The outstanding financial success of Warren Buffett, for example, is testimony to the effectiveness of fundamental analysis.

The field of technical analysis has expanded in recent years, but finding success in it is not easy, as successful technicians guard their trade secrets carefully. Yet, there are others who promise more than they can deliver.

Market players tend to be either technical or fundamental in their approach. The choice really depends on one’s personal aptitude. The logical appeal of fundamental analysis attracts rational minds, but an in-depth knowledge of finance and economics is an advantage.

Technical analysis is more suited to market players who are comfortable with the reading of charts. It does not require a quantitative nor mathematical mind, more an aptitude towards chart reading or “visual intelligence”, which can be developed over time.

The bottom line

Some practitioners believe that combining both approaches may be the way to get the best of both worlds. But In the end, one should recognise the constraints of each approach, and select the approach that suits one’s aptitude, and then try to excel in it.

BC Low is the president of Technical Analysis Consultancywhich delivers seminars to financial institutions.
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