Thursday, February 23, 2012

Some Thoughts On Investing Vs. Speculating And Fundamental Vs Technical Analysis...


"The attempt to predict accurately the future course of stock prices and thus the appropriate time to buy or sell a stock must rank as one of investors most persistent endeavors."

Technical analysis (a.k.a. charting) is, at its most basic, the creation and interpretation of stock charts. The most fervent practitioners are called "chartists". Most chartists believe the market is 10% logical and 90% psychological. That is, chartists believe that the market is driven by the average sentiment of investors at any given time. This is very much like choosing stocks based on what you think other investors think (or will think) about the stock in the future. It's more about analyzing and predicting crowd behavior than the success or failure of a given business.

Fundamental analysis is the antithesis of technical analysis. The fundamentalist believes that the market is 90% logical and 10% psychological. They are called fundamentalists because they see the future value of a stock as the result of the future condition of the business fundamentals. That is, the value of the stock is the result of the value of the underlying business - ie. growth, earnings, cash flow, debt, etc...

Which is right?

A primary tenet of charting states that all that is knowable about a given stock is already reflected in it's price. This means that the historical chart contains the aggregate effect of all past dividends, splits, earnings, growth rates, etc - all the fundamental aspects of the stock.

The secondary tenet is that prices tend to move in trends - downward trends,upward trends or flat lined. A head-and-shoulders chart means the same for Google stock as it does for Alcoa. Chartists believe that any important fundamental factors of a stock are already "baked into" the current price. All that is knowable is reflected in the chart.

Charting works wonderfully, until it doesn't. Trends reflect the mass psychology of the crowd and can hence sustain a stock price to the point where it becomes self-perpetuating. The problem is that this leads to bubbles, and bubbles eventual burst. Charting and technical analysis can work in the short term,but when the trend reverses you can get caught catching the blade of the falling dagger.

Falling trends alone is very speculative. It's investing in stocks instead of businesses and it ignores all rationale in favor of crowd psychology. Speculators and chartists end up investing in something they don't (and can't) understand. The trend is ultimately, rarely explainable. It may be real, but it is also usually ephemeral and without a logical cause it is impossible to make a rational investment- you are simply chasing trends.

All this trend chasing leads to much trading, and this can quickly add up to high trading fees. It's not uncommon for traders (i.e.: speculators/chartists) to eat up their profits in trading fees.

All this does not mean that technical analysis is bad or useless. It just depends on how you use it.

Asking if Technical analysis is better than Fundamental analysis is a little like asking if Einstein's Theory of Relativity is better than Quantum Mechanics. The answer is neither - they are two different ways of viewing the universe and each works in its own space.

Einstein's theory predicts how matter behaves in the universe on a large scale while Quantum Mechanics predicts the behavior of matter in the sub-atomic realm.

Fundamental analysis works best for the long haul (like Einstein's theory) because the trend line is trending toward infinity. For example: the stock market as a whole will certainly be higher in 100 hundred years than it is today. But as that time period lessens, it becomes harder to say with certainty where prices will be. Can you make the same prediction of prices 1 year from today?

Technical analysis can help to predict these movements over shorter periods of time, but as discussed above the fees associated with chasing these trends can quickly eat up your returns.

My personal view (and this is just my opinion) is that investors should favor fundamental analysis for picking stocks to invest in for the long term (3 years or more), but use technical analysis to determine the bets (or at least better) time to buy and sell.

By using fundamental analysis to create you watch lists, and technical analysis to develop your trigger points you are utilizing a holistic approach that makes the best of both. 
Most people don't realize that both fundamental analysis and technical analysis have a great power to generate consistent, reliable and higher than average return. To apply that Strategy, however, you should really learn about how to apply this strategy when it really counts. To learn in more depth how to do just that, i recommend reading
Related Posts : Charting, Fundamental analysis, Investing, Technical analysis

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