One of the highly debated topics in the financial world is choosing between Fundamental Analysis and Technical Analysis. Many have their own opinions causing a lot of people being torn which one to use.
In today’s episode of #AskDrWealth, we are going to help you find the one for you. We are going to discuss with you about the differences between Fundamental Analysis and Technical Analysis.
On top of that, we will also include the limits to each of the approaches.
So read on to continue…
Let us first begin with the basics by defining the terms:
What is Fundamental Analysis?
Let’s define ‘Fundamental Analysis’.
For its usual definition, Fundamental Analysis is a method used to evaluate a security in an attempt to measure its intrinsic value through examining related economic, financial and other qualitative and quantitative factors.
For most of the investors, these factors they use are things like financial statements, or it can even be like economic indicators to gather some sensing on the value of a particular investment.
Now how did this come to be? What is the primary belief that led to this method?
Well, this came to be from the belief that price is NOT always equivalent to the value of the investment. Which means, if the price is BELOW the value on investment, it becomes generally a GOOD buy for them.
What is Technical Analysis?
Now, let’s define ‘technical analysis’:
Technical Analysis is another method employed to evaluate securities and attempt to predict their future movement by analyzing statistics gathered from activities, such as price movement and volume.
To add a situation to that, what most people understand is that they usually derive information like ‘Buy’ and ‘Sell’ signals from the chart itself. And this ‘chart’ is the representation of the stock prices movement over time.
Also, it can be other technical indicators such as: derivation of price, or even volume data.
Based on them, people make certain decision on whether a stock is going to be bought or sold. Now why is this so?
The primary belief of technical analysis is that price REFLECTS all the information that is available. So whether there are some changes in the fundamental of the business and others, technical traders believe that the information has already been priced in.
With those definitions above, you can see how there’s a fundamental difference in the beliefs. This is the reason why these two camps use very different approaches. Thus, they can’t really agree with one another.
Let us now further understand the two by learning about their limits.
The Limits of Fundamental Analysis
As we have mentioned, the belief in fundamental analysis is that value is very important to determine the value of the business. However, there are a few limitations attached to this and we have here the two of them:
Limit #1: Information is False
For example, they have to look at the financial statements and things like that. However sometimes, the information that is provided may not be 100% accurate.
So for example in Singapore, let us cite an incident in the past with even an SGX listed company:
The PRC managed companies listed in Singapore, which are called the ‘S chips’, had many incidents of reporting FALSE numbers. That misled investors to think that there’s a lot of value in a company when in fact it is all made up.
So when the information is false, fundamental analysis breaks down. It’s actually acting on false information to provide certain valuation. And this is actually the key issue associated with fundamental analysis.
Limit #2: Precise Entry and Exit
The second thing is related to when a stock is ‘undervalued’. Undervalue pertains to stocks/securities that are selling for a price presumed to be lower than its intrinsic value. Now what is wrong with this?
For example, when we say a stock is worth $2 but the price for it now is shown as $1, we know that it is obviously undervalued. And if it goes to 80c, it is still undervalued and if it goes to 60c, it is still even more undervalued right?
For fundamental analysis, this means another problem:
There isn’t a very precise entry and exit for all this positions. It gives you a very wide range. This makes some investors uncomfortable because they are not sure what to do at a particular point in time.
The Limits of Technical Analysis
The core belief of technical analysis is that price reflects all information. But this belief is still as shaky as the fundamental analysis. That said, technical analysis also has its limitations.
Limit #1: Low Transacted Stocks
Regarding the core belief about price reflecting all information, the limit is that this is only true if there are enough transactions to validate the stock prices.
For example, if there is very low volume or lowly transacted stocks in the market, technical analysis doesn’t really work. The reason for this is because one or two buyers and sellers only determine the prices, which is not enough validation.
The price discovery is very weak in that sense.
So this means that the belief then breaks down because the price is not reflecting enough opinions of the market participants.
Limit #2: Managing Large Capital
The second thing is for technical analysis is how it is usually difficult to manage large capital. This method usually requires agility and nimbleness in order to go in and out of the market. Having a too large capital slows down the agility.
So in the process, it becomes very stressful for the trader to want to take out or take up position. They might end up moving the markets.
How One Benefits from the Other
If you are sharp, you would have already noticed that the limitations of technical analysis is actually the benefit for fundamental analysis, and vice-versa.
Take a look at this table based on what we have just discussed above:
| Fundamental Analysis | Technical Analysis | |
|---|---|---|
| Requires accurate financial numbers | Yes | No |
| Provides Exact Entry / Exit Price | No | Yes |
| Investment Duration | Long | Short |
We will give you one example:
Let us say that the information is false. However, there are insiders who know that a company may not be doing as well. This may be reflected in the stock price. They may not be trading at very good prices or don’t have very good price trends.
Another thing is the case of “precise entry and exit” that doesn’t exist in fundamental analysis actually exists in technical analysis as well. Managing a large capital is difficult for technical analysis because they need precise entry and exit.
On the other hand, for fundamental analysis, it becomes an advantage because investors can take a long time, or a long horizon, to add up position or get out position.
With everything we have discussed about, we have come to identify the core differences between fundamental analysis and technical analysis.
On a personal note, I prefer to use Fundamental Analysis to invest because:
- I found it easier to make money
- I’ve also seen more successful fundamental analysis investors than technical analysis traders.
Now, some of you might be thinking: “why not just combine both together?“
Well, you can actually do that. But only provided that it doesn’t lead you to “paralysis by over-analysis” because sometimes you may receive mixed signals and in the process wouldn’t know what to do about them.
So that’s it for today! I hope that you have found your edge in the market be it by way of ‘fundamental analysis’ or ‘technical analysis’.
Which approach do you prefer?
Let us know in the comments below!
