The difference between fundamental and technical analysis is large. Most investors, if they understand the differences, believe they are one or the other.
In reality, most investors use a combination of the two types of analysis. Personally, I consider myself an 90% fundamental value and 10% technical investor. Investment decisions should be based primarily on valuation.
Fundamental Stock Analysis
Fundamental stock analysis is the process of financial statement analysis, and an examination of company products, management, competitors, markets, and economic environment to determine the value of its’ stock. Both historical and present data can be used, with the goal being to forecast how the stock will perform in the future.
The most common data used in fundamental research and analysis would be revenues, expenses, profits, earnings per share, assets, liabilities, book value, dividends, cash flow, and projected earnings growth rates. Key ratios would include price/earnings ratio (P/E), dividend yield, dividend payout ratio, enterprise value ratios, return on equity, price to sale, price to book value, and return on capital ratios.
An analyst would evaluate the data and ratios in comparison to the universe of stocks available. The goal of the investor is to invest with an margin of safety. That means attempting to buy investments that sell below their fundamental value.
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Technical analysis is the forecasting of the future price of a financial asset using primarily historical price and volume data. Technical analysts believe that all information is reflected in the price; making fundamental analysis unnecessary. Information from the analysis of price is used to predict what the future price will be.
There are several different popular schools of technical analysis, including Elliott Wave Theory, Dow Theory, and Candlestick Charting. All attempt to use price patterns and price trends to make forecasts of future prices. The central idea is to estimate the likelihood of price movements and make trades based on those with the best risk/reward ratio.
When evaluating price, technicians frequently use overall trend, areas of support and resistance on the charts, price momentum, volume to determine buy/sell pressure, and relative strength compared to the market. They would also look for price patterns, study moving averages, and examine indicators such as put/call ratios.
Fundamental or Technical Analysis?
Using both fundamental and technical analysis makes some sense. Both provide information that adds insight to investment analysis. However, I don’t believe technical analysis alone can provide the information needed to make investing decisions.
I always use fundamental value analysis first; then I might use technical analysis to see if there is a reason I should avoid an investment (i.e. recent break of support, increasing volume while the price declines, etc.) If both fundamental and technical analysis offer the same answer, then I have a higher level of probability for my investment decision. If technical analysis provides warning signs then I might be patient and wait for a more ideal entry point.
Remember, you don’t have to invest in an asset until the odds are heavily in your favor. Because of the difference between fundamental and technical analysis, using both can increase your probability of making wise investment decisions.
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