Risks are inherent in both investing and trading. Making informed decisions helps in minimizing these risks and increasing the potential for generating returns. There are two general approaches in guiding investment or trading decisions. These are fundamental analysis and technical analysis. Both represent two diverging paradigms on how to select securities or assets to invest in, and when to buy or sell these chosen securities or assets.
Explaining the Difference Between Fundamental Analysis and Technical Analysis
The entire fundamental analysis vs technical analysis debate represents two competing schools of thought or paradigms pertaining to investment and trading decisions. These two share the same purpose of evaluating investment opportunities and predicting the future performance of specific securities or assets. Those who champion the former focus on the intrinsic value of an investment while those who promote and use the latter focus on price and volume data. Nevertheless, in deciding which of the two is the better approach, it is important to understand the following differences:
1. General Definitions
Understanding the difference between fundamental analysis and technical analysis first requires understanding their general definitional scope. The former is a method used to determine the intrinsic value of applicable securities or assets by examining relevant internal and external factors, and arriving at conclusions based on this examination. The latter is also another method for determining the value of securities or assets but it focuses on analyzing statistical trends derived from historical price movements.
2. Principles and Purpose
The core principle of fundamental analysis revolves around the concept of intrinsic value. This means that the current value or price of an investment does not always reflect its true worth. The purpose of this approach is to recognize undervalued or overvalued securities or assets based on their intrinsic worth. The core principle of technical analysis centers on a belief that the price of a particular security or asset and the volume at which it is traded reflect all relevant information affecting its future performance.
3. General Assumptions
It is also important to highlight the fact that fundamental analysis is based on the assumption that inefficiencies in the market exist and the price of a particular security or asset will eventually align with its true or intrinsic value by virtue of market correction. The assumption of technical analysis is that the previous and current price and volume of a security or asset reflect all pertinent information affecting its future price and volume, and that price and volume patterns repeat due to human behavior and market psychology.
4. Tools and Data Sources
Another difference between technical analysis and fundamental analysis is the tools and data or sources of data used in the analysis. The former relies on financial statements, internal information, economic data, market or industry research, and current events. These can be obtained from primary sources and secondary sources like news and research companies. The latter utilizes historical data that includes price movements and trading volume data. Most of these can be obtained through third parties.
5. Specific Skills and Techniques
Furthermore, aside from the different data sources, approaching either of the two requires a different set of skills and using different techniques. Fundamental analysis requires computing and studying financial ratios, collecting and analyzing macroeconomic data, and evaluating and synthesizing different quantitative and qualitative factors. Technical analysis necessitates the need to read and understand graphs or charts of historical data or price movements using techniques such as moving averages, chart patterns, and oscillators.
6. Applicability
It is also important to note that fundamental analysis and technical analysis have similarities and differences in terms of applications. Both can be applied to stocks, indices, bonds, commodities like gold and oil, and pooled funds like mutual funds and exchange-traded funds. The former is also more applicable to real estate. The latter is also more applicable to forex trading, cryptocurrencies, and commodities but is less effective in bonds and real estate because these two are fundamentally driven.
7. Suitable Time Horizon
The fundamental analysis vs technical analysis debate also includes taking into consideration time or investment horizon. Fundamental analysis has a longer-term perspective and is used for long-term investment decisions. This makes it more suitable for buying and holding securities or assets for a period of at least two years. Technical analysis is better suited for shorter timeframes that can be as short as an hour or a day and only as long as weeks or months. This makes it more suitable for short-term and intraday trading.
Choosing Which Between Fundamental Analysis and Technical Analysis is Better
The two have their respective strengths and weaknesses. The main drawback of fundamental analysis is that it is not suitable for quick decisions because of the time and effort it needs to gather and analyze relevant quantitative and qualitative data. Technical analysis is more suitable in a setting that is characterized by a faster investing or trading pace but is not ideal for long-term investment strategies like wealth preservation.
It is important to underscore the fact that fundamental analysis can be useful for securities or asset classes that have substantial amounts of data that can be obtained to determine their intrinsic value. Technical analysis is generally considered more effective in liquid markets or in securities and assets that have high trading volume.
The two can be used together. For example, in stock investing, fundamental analysis can help in pinpointing stocks with strong financials and growth potential, and then using technical analysis to determine a specific entry point. Technical analysis can also be used for confirming or refuting the conclusions of fundamental analysis. Nevertheless, by combining both, investors can get a more well-rounded picture of a potential investment.
