Fundamental Analysis versus Technical Analysis

There are two general schools of stock analysis: fundamental and technical. This feature describes the two schools and the key differences between them.

Fundamental Analysis

Fundamental analysis requires, among other things, a close examination of the instrument, in order to estimate whether the instrument’s price is undervalued or overvalued. A good deal of reliance is placed on annual and quarterly earnings reports(in case of stocks), the economic, political environment, as well as any current news items or rumors. Simply put, fundamental analysis concerns itself with the “basics” in assessing the worth of an instrument. Fundamental analysis may be the preferred method to use for mid to longer term investors. However, it is not suitable for use by day traders because of the amount of research required, and the fact that trades are entered into and exited within a very short time frame.

Technical Analysis

Technical analysis does not concern itself with basics or fundamentals. Rather, technical analysis involves the study of a stock’s trading patterns through the use of charts, trend lines, support and resistance levels, and many other mathematical analysis tools, in order to predict future movements in a instrument’s price, and to help identify trading opportunities.

The basic foundations or premises of technical analysis are that a instrument’s current price discounts all information available in the market, that price movements are not random, and that patterns in price movements, in very many cases, tend to repeat themselves or trend in some direction.

The main problem with fundamental analysis is that its indicators are removed from the market itself. The analyst assumes causality between external events and market movements, a concept which is almost certainly false. But, just as important, and less recognized, is that fundamental analysis almost always requires a forecast of the fundamental data itself before conclusions about the market are drawn. The analyst is then forced to take a second step in coming to a conclusion about how those forecasted events will affect the markets! Technicians only have one step to take, which gives them an edge right off the bat. Their main advantage is that they don’t have to forecast their indicators.

A very large number of technical indicators have been developed over the years, including the widely used overbought/oversold indicators such as the Relative Strength Index, and the trend following indicators such as Moving Averages.

While technical analysis can be a great help in trading the market, no technical indicator is infallible. Further, technical analysis is only as good as its interpreter. Finally, a significant of time must be spent in learning the principles of technical analysis, and in how to properly interpret the various charts and other technical indicators.