Friday, May 25, 2012

Fundamental vs. Technical Analysis (a Primer).

Some would argue that both Technical Analysis and Fundamental Analysis attempt to predict the future price of a stock, and hence the best time to buy or sell the stock. They would say that these two techniques are complimentary investment tools.

Others argue that Fundamental Analysis is a thing of the past, and that modern computer power puts Technical Analysis in a place of supremacy.

Technical Analysis.

Technical Analysis is a form of prediction used by castle-in-the-air investors. Castle in the Air investing focuses on stocks that have momentum to carry them higher. It relies heavily on charts and psychology.

Practitioners of Technical Analysis are sometimes called "chartists" because of their slave-like devotion to charts to the exclusion of all else. Pure chartists believe that the market is 10% rational and 90% emotional or psychological.

Chartists try to out guess other investors without regard to underlying business of a stock holding. A cynic might say that the Chartist or Castle in the Air Investor is simply hoping to take advantage of the Greater Fool Theory.

Chartists believe that all knowable information is reflected in the stock chart (i.e. past price and current trend of the price). Chart shapes are of supreme importance to Technical Analysis, but a Head And Shoulders Pattern means the same thing regardless of the stock whose price chart makes the formation.

In Technical Analysis, trends might perpetuate themselves for 2 reasons:

  1. Mass psychology and crowd instinct - no one wants to miss out, so investors chase performance. This is often at the heart of stock market bubble.
  2. There may be uneven access to key information. Insiders learn of game changing information and buy shares. Insiders then tell friends who buy shares. Institutional money managers learn of the info and buy massive amounts of shares. Individual investors see price rise and pile on (see #1 above.)

Technical Analysis and Price Chasing Psychology.

Here's an example of how Technical Analysis attempts to explain momentum in terms of price chasing.

Stock xyz currently sells for $50 per share. The price then falls to $40. Next, the price rises again to $50 only to drop back down again as investors who bought at $50 sell their shares in the hopes of breaking even. This $50 point is then considered a level of resistance.

As $50 per share investors sell, other investors see the stock fall to $40. Investors who didn't buy xyz at $40 and see it rise to $50 feel like they missed out, so when the price drops to $40 they get on board and push the price up again. In this example, $40 is considered a support area.

It seems logical and makes common sense, but it doesn't explain every move in a stock price and it doesn't always predict where the price is headed next.

Where Technical Analysis goes wrong.

This kind of approach lends itself well to timing the market, day trading and speculation. Transaction fees and taxes often eat up any profits that may be found.

Fundamental Analysis.

Fundamental Analysis is sometimes called Firm Foundation Theory and it focuses on the underlying company rather than the stock price.

If Chartists believe the market to be 10% rational and 90% irrational, the Fundamental Analyst believes the market is 90% logical, 10% psychological.

Fundamental Analysis seeks to determine the true underlying value of the stock or company, usually called its intrinsic value.

There is perhaps no more prominent investor associated with type of investing than Warren Buffett.

Buffett epitomizes the fundamentalist approach. He tends to ignore the day-to-day "chatter" of the market and only buys a stock when he feels the price is at a discount to the company's intrinsic value.

Which is Better - Technical Analysis or Fundamental Analysis ?

This whole thing is rather like debating whether General Relativity is more accurate than Quantum Mechanics . Both represent different aspects, or slices of the universe - in the case of Technical Analysis and Fundamental Analysis the universe is the stock market.

In my experience and opinion, Technical Analysis can be helpful in explaining - and maybe even predicting - short term fluctuations of a stock price, but Fundamental Analysis proves to be the winner in the long term. Some of this is because the market tends to be more of an efficient market over time where stocks come to reflect the value of the underlying business, and some of it is because short term trading (associated more with Charting than Fundamental Analysis ) leads to higher fees and taxes that eat away at profits.

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