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Wednesday, February 3, 2010

Introduction to Technical Analysis and Fundamental Analysis

Introduction to Technical Analysis and Fundamental Analysis

Let me begin by stating that I'm a believer of both camps of technical Analysis and fundamental Analysis. This article is primarily focused on the very basics of what is technical and fundamental analysis, and some of the criticisms on them.

Technical analysis and fundamental analysis are merely two different analysis methods. In a nutshell, technical analysis looks at price actions and indicators, and uses this data to predict future price movements. Fundamental analysis, however, looks at economic factors, business fundamentals, stock price vs value, etc.


Similarities between Technical and Fundamental Analysis

Technical analysis and fundamental analysis both aim to help determine a buy-in price and sell price for a stock. By doing so, both analysis helps to reduce the probability of losing and increase the probability of winning.

Gambling dens earn by the concept of probability. So does technical and fundamental analysts. Technical analysts go for low risk high probability setups. Fundamental analysts reduce risks or increase probability of success by determining an intrinsic value for the company and enter with a margin of safety.

Both types of analyses give an advantage to the analysts as compared to a normal layman who buy based on hearsay, gut feel and look-look-see-see.


Differences between Technical and Fundamental Analysis

The main thing a fundamental analyst does is to analyse the company's business prospects (economic and industry factors), financial statements, cashflow statements, and attempt to calculate a value for the company, using NAV, P/E ratios, P/B ratios, Discounted Cash Flow Valuations method, etc. If the price is at a discount, i.e. at a margin of safety, then buy. If it's not, then do not buy, or sell. "Price is what you pay, value is what you get."

On the other hand, a technical analyst believes that company fundamentals are all reflected in the charts. All there is to know about the company can be found in the charts. Technical analysis is about mass human psychology, and the more people using it, the more self-fulfilling it becomes. There is little issues with any creative accounting a rouge company might do. "Charts do not lie."

The timeframe of a fundamental analyst is also generally longer than that of a technical analyst. The main reason is because for a fundamental analyst who analyses financial statements, such statements only come out quarterly, hence the time lag. However, for a technical analyst, the time frame is generally much shorter, from a matter of hours to days or months.

Lastly, fundamental analysts usually average down when there's value. Technical analysts usually average up on breakouts.


Criticisms of Technical Analysis

Non-believers of technical analysis
(who are usually staunch fundamental analysis believers) see it like gambling. Any attempt to predict future price actions is a form of guessing and gambling. They fail to see how drawing of trendlines here and there like little kids, and seeing technical indicators of past price actions, will give an idea of a stock's worth. "Do not predict the market", they say.

The fact that most use against technical analysis is that the world's richest man, Warren Buffett, uses mainly fundamental analysis. Also, some of the people whom I have come across tells me that their earnings are more when they use fundamental instead of technical analysis.

However, from personal experience, technical analysis does work when done correctly. Strict money management and tight cut loss rules are paramount to the success of technical analysis. In addition, the mindset of a technical analyst must be different from a fundamental analyst.


Criticisms of Fundamental Analysis

The main attack on fundamental analysis is value traps and fake information. Companies such as Enron, Chartered, FerroChina, Beauty China, are used as examples. The critics I know so far on fundamental analysis had bad experience with buying and holding. A lot of Singaporeans also lost money on investing in the GLC Chartered Semiconductor. In short, fundamental analysis has failed them.

The second criticism on fundamental analysis has its basis in the theory of efficient market hypothesis. The theory states that the market's price is always the correct one. Any past trading information is already reflected in the price of the stock and, therefore, any analysis to find undervalued securities is useless.

With regards to the first criticism, it's in my belief that these people had not done proper homework on fundamental analysis before making their buy decisions. Also, they were greedy for more, even when prices are high. Everyone hopes to be the next Warren Buffett, but are sorely disappointed. Just like technical analysis done wrongly would lead to monetary losses, so would fundamental analysis!

The efficient market hypothesis theory hold more weight in my opinion, which is the main reason why I do not totally forego technical analysis as part of my arsenal of determining a buy-in price.


Combining Technical and Fundamental Analysis?

Although technical analysis and fundamental analysis seems to be radically different, in actual fact, they are linked at times. More often than not, great fundamentals are usually together with great technical setups.

As for me, I have experienced some success in combining the two analytical techniques, particularly for Macquarie International Infrastructure Fund and Starhill Global REIT. Stocks are identified using fundamental analysis to determine if a stock is undervalued. Technical analysis is then used to attempt an optimal entry into the stock to improve the gains on investment and obtain the best margin of safety. Averaging down is done on buying every support. In addition, if an extremely bearish technical setup is seen, then even though fundamentals look good on reports, we have to beware of a possible bad news announcement coming soon. It would then be good to wait for entry.

On the other hand, a technical analyst could look into fundamentals to add strength and conviction to a technical buy/sell signal.

Mixing these two schools of thoughts isn't an easy process, and is sometimes frowned upon by the most devoted technical analysts or fundamental analysts. The strategies and mindsets of each is different, and not being clear in differentiating your strategies and mindsets could lead to poor buy-ins. However, for the recreational investor/trader like me, combining and understanding these two schools of thoughts certainly offer benefits.... At least you have an analytical reason for buying instead of blindly listening to other "analysts".

4 comments:

  1. What about a takover offer for a company that nobody was expecting. I have nothing against technical analysis Although I remain skeptical about it but I do find it interesting to listen or read about it. I am at heart a fundalmentist when it comes to investing in securities because I believe that invariably and in the end a companies stock price must at some point reflect the performance of the business. Their many stocks that have increased tremendously in value apple computer traded at just 5 dollars in 1998 today its around 400 dollars also petsmart stock traded at just 2 dollars in the year 2000 now its trading around 50 dollars a share theirs many other stocks but to many to list here. So you can still make lots of money buying and holding if you choose the right type stocks.

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  2. This is a site to view volume and technical analysis of stock chart analysis. This site provides leading technical indicator analysis and provides a great stock screener.

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  3. Thank you for taking your time out explaining the difference betweent the two analysis. I really do appreciate your effort, and it really helps. Right now, am just dealing and analyzing binaries www.24option.com binary trading, that would mean I can now differentiate what kind of trade I am doing. Thanks again for this post.

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  4. I tried both but more incline towards value investing using warren buffett's methodology. I attended a formal value investing workshop after attended a value investing seminar, http://valueinvestingsingapore.sg. The value investing options strategy works well for me. Less reliance on TA tools these day for me.

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