Making sound investing decisions can be a daunting task. With the abundance of data available, it is difficult to sort and filter the information you need. If you separate investment strategies into the two major divisions – fundamental and technical analysis – you can see the strengths and drawbacks of each and select the approach that makes more sense for you.
With fundamental analysis, you seek to understand trends in the economy, business sectors and companies to determine if stocks are priced fairly given the prevailing economic conditions. You begin your analysis by examining the economic outlook to determine which industry groups are likely to benefit. Understanding the group is as important as picking the industry leaders – the top firms in a stagnant or declining industry are not going to be wise picks. Conclude your analysis by studying the leaders in the rising industries, looking at key statistics, management and the business plans. Based on your analysis, if a stock is undervalued, then it is a buy.
Fundamental analysis is time-consuming. You cannot quickly locate and absorb the information you need to make thoughtful stock picks. Your judgments are subjective, as is your definition of fair value. You may need to use different criteria to evaluate different industry groups, which will also be time-consuming. Since all information about stocks is public knowledge – barring illegal insider information – stock prices reflect that knowledge. If stock prices are based on all known information, then they can neither be undervalued nor overvalued. But information flows are imperfect, and if your exercise due diligence, you will be more successful than those who do not.
Technical analysis is based on the assumption that patterns in stock price movements repeat themselves and can determine the best times for you to buy and sell. Analysts use different charting styles to plot price movements. One of the more popular is the candlestick chart, named because it resembles a candle. The figure for each trading period is plotted to show the high and low prices for the period, along with the opening and closing prices. Trading patterns have descriptive names like head-and-shoulders, double bottom and cup-and-handle. Charters add trend lines to predict future price movements.
Critics of technical analysis compare it to reading tea leaves. There is nothing, they say, about a chart formation that necessarily makes a stock move in a predictable manner. On the other hand, if enough followers believe in the predictive power of the chart, they will engage in the buying and selling activity that will make the prediction come true. Fundamental analysis is primarily used by investors who buy and hold stocks for a period of time, while technical analysis is most frequently used by traders looking to make short-term profits. Since technical analysis is primarily a market timing tool, it can be implemented effectively in conjunction with fundamental analysis. Learn the fundamentals, make your investing decision and time your purchase or sale with technical analysis.
- Creatas/Creatas/Getty Images