Technical Analysis Vs. Fundamental Analysis: Which Approach Is Better?
If you've been trading for a while, you're likely familiar with Technical analysis and Fundamental analysis. Today, we'll discuss the key differences between these 2 types of analysis.
We'll dive into how you can use these strategies in your investing journey. Plus, we'll provide some insight to help you figure out which approach might be the best fit for your investing style. Stay tuned for more!
What Is Technical Analysis?
Technical analysis is a method used to evaluate securities by analyzing statistics produced by market activities, such as past prices and volume. It utilizes charts of stock prices and various analytical tools to assess a stock's strength or weakness and forecast future price fluctuations.
For instance, the VWAP indicator is often used to identify possible support or resistance.
Instead of focusing on a company's underlying fundamentals, technical analysis seeks statistical patterns on stock charts that could predict future price and volume shifts.
Why? The premise is that stock prices already account for all publicly available information about a company, rendering detailed examination of balance sheets, income statements, or other financial data unnecessary. As such, technical analysis is typically used for shorter-term trades due to its emphasis on price and volume movements.
Key Metrics Used in Technical Analysis
Technical analysis is all about studying an asset's past performance to predict its future price. Those who swear by it believe that every asset's chart has a unique story to tell by checking the key metrics.
Technical indicators
Technical Traders anticipate price movements using technical analysis strategies such as moving averages, Fibonacci retracements, and Bollinger bands.
Candlestick patterns
They also use the 'candlestick' technique to analyze charts, where green and red denote bullish and bearish movements respectively. The size of the candlestick shows the price difference between opening and closing of a market, while 'wick' shows its highest and lowest prices. Candlestick patterns over time are crucial in understanding the market psychology.
What Is Fundamental Analysis?
Fundamental analysis evaluates securities by measuring their intrinsic value. It examines a company's earnings, sales, competition, management quality, and macroeconomic factors like the economy and industry conditions, and even indirect factors such as media coverage.
Key Metrics Used in Fundamental Analysis
Key metrics to consider include earnings per share (EPS), price to earnings (P/E) ratio, P/E growth, and dividend yield to examine a company's earnings.
Also, some traders will react to a country's macroeconomic data, such as GDP or inflation, and changes in its monetary policy.
Applying Fundamental Analysis in Investing
Fundamental analysis can be applied by investors in several ways. Some may focus on the overall health of the economy and how that might impact various industries. Others might focus on analyzing a company's potential growth in the future.
Here are the 2 main approaches for investors to apply fundamental analysis in their trading.
Growth investor's strategy
Growth investors prioritize a company's future potential. Even if a new company isn't immediately profitable, strong initial revenue growth can attract these investors. If the company has an innovative product or competitive advantage, investors can drive the stock price up. They often focus on a company's historical and projected revenue growth rates when investing.
An example of this could be AI innovation with Nvidia. As the use of AI is expected to increase, investors predict a surge in demand for graphic cards. This could drive the price to an all-time high by 2024.
Value investor's strategy
Value investors target stocks priced below their actual value based on company health and fundamental metrics. They often choose industry leaders, who are past peak growth but pay steady dividends.
Value stocks typically have low P/E ratios, above-average dividends, and trade below their book value. In essence, value investing is about buying great companies at good prices, not just cheap stocks.
Technical Analysis Vs. Fundamental Analysis: Which Approach Is Better?
Fundamental and technical analysis are 2 common ways to sort and pick stocks. How and when to use them can be a matter of personal style, but each has its strengths.
Fundamental analysis attempts to identify stocks offering strong growth potential at a good price by examining the underlying company's business, as well as conditions within its industry or in the broader economy.
Fundamental Analysis Technical Analysis Use Long-term investing Short-term trading Purpose Identify fair asset value Find price trends and optimal trade points Reference Data Past and present data, macroeconomic indicators, company earnings Historical price data Trader Type Long-term investor Short-term trader Pros Identifies undervalued stocks Optimises trade entry and exit points Cons Not for day trading; varies across sectors Not foolproof; relies on lagging dataPros of Fundamental Analysis
Fundamental analysis helps identify long-term asset trends and underlying values, increasing investment confidence. Successful strategies allow investors to identify value stocks, like Warren Buffett's approach to undervalued stocks.
Though primarily used long-term, fundamental analysis is useful short-term around earnings season due to increased trading volume and stock price volatility. A savvy investor can determine whether a stock's movement is justified by its financial data, creating buy or sell opportunities.
Cons of Fundamental Analysis
Value investing, while beneficial long-term, may not serve day traders well, particularly outside earnings season due to unpredictable short-term market sentiment.
A one-size-fits-all approach to fundamental analysis is challenging, given the sector-specific characteristics. For instance, the tech sector's higher P/E ratios may lead to overlooked returns. Furthermore, fundamental analysis depends on subjective macroeconomic data and surprise earnings, requiring constant portfolio reassessment.
Pros of Technical Analysis
Understanding price trends and signals from assets can help traders identify key entry and exit points, enhancing returns. Technical analysis can become a self-fulfilling prophecy, as sufficient volume following the same indicators can influence asset prices. Accurate identification of technical phenomena allows traders to anticipate market moves.
Cons of Technical Analysis
Though technical analysis can identify potential trends, it's not infallible as all assets are subject to unpredictable shocks. Traders should use various indicators and remember that past performance doesn't guarantee future returns.
Learn Both Strategies
Fundamental and technical analysis, in combination, can reveal critical information about a stock's prospects. Using both methods can cater to possible changes in investment duration. For instance, a trader might use fundamental factors for selecting the stock and technical factors for identifying precise entry or exit prices.
How to combine fundamental and technical analysis
Traders should understand both fundamental and technical analysis to make informed trading decisions, especially for short-term trades. Here's how to combine these methods:
Volume
Investors often use trading volume to predict future stock movements. This helps in understanding market sentiment and determining the asset's value. Rising volume may indicate a bullish run, while falling volume can suggest dwindling interest.
Short-Term Price Movement
Although value-focused investors are interested in long-term asset value, monitoring short-term movements can help achieve a better buying or selling position. Analysts watch for key support or resistance points and short-term moving averages to inform their strategies.
Reactions to News
Analysts can use a stock's price history to understand its reaction to recurring events like earnings announcements, macroeconomic data releases, or policy changes. For instance, housing stocks often react to interest rate changes, which can guide future investment decisions.
Tips to Find the Right Stocks
Stock selection doesn’t have to be difficult, but you do need to be flexible. Look for markets that are moving but also be willing not to trade. Consider going short as well as long. Finally, and perhaps most importantly, you need to be disciplined. Don’t let the inevitable bad trades turn into a disaster. Keep your losses small and live to trade another day.
Fundamental vs Technical Analysis Takeaways
Both strategies have strengths and weaknesses, and the choice between them depends on the trader's style and objectives.
Successful traders often use a combination of both fundamental and technical analysis.
Ultimately, the best approach is to be flexible and use the analysis methods that best suit your trading goals and risk tolerance.
Fundamental analysis determines an asset's 'fair value' using financial and macroeconomic data.
Technical indicators use historical data to predict future prices through methods like MACD indicators and candlestick analysis.
Fundamental analysis is ideal for long-term investing and finding undervalued stocks, whereas technical analysis suits day traders.
Fundamental analysis isn't suited for short-term trades or cross-sector replication. Technical analysis isn't entirely reliable as it's based on past data.
Combining both analyses involves studying volume trends and tracking asset movements and reactions over time.
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