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What is the difference between technical vs fundamental analysis? Why might a combination of both be the best approach?
Technical vs fundamental analysis are the two main methods of security analysis. Technical analysis aims to predict future stock prices using graphs of past price movements, while fundamental analysis opts for an in-depth study of the firms’ balance sheets, taxes, and earnings. Each approach has its advantages and disadvantages.
Keep reading to find out the difference between technical vs fundamental analysis.
Technical vs Fundamental Analysis
The two primary methods of security analysis that financial professionals use are technical analysis and fundamental analysis. Here are the key differences between the two, and the recommended way to approach technical vs fundamental analysis.
Technical analysis relies on stock charts—graphs of past price movements and trading volumes—to predict future price movements.
Technical analysts adhere to two primary principles: (1) that all economic data—revenues, dividends, and future performance—are reflected in a stock’s past prices; and (2) that stock prices tend to follow trends (if a price is rising, it will continue to rise, and vice versa).
Fundamental analysis attempts to predict a firm’s future earnings and dividends by in-depth study. Fundamental analysts pore over firms’ balance sheets, earnings reports, and tax rates; they even, on occasion, pay personal visits to companies to assess their management teams.
Fundamental analysts also study the industry in which a company is operating. They do so to understand what is making current companies successful in that space—so they can recognize an innovator when it comes along.
Combining Technical vs Fundamental Analysis
Some analysts actually use a combination of technical and fundamental analysis to place their bets. For investors looking to mix the two techniques, economist Burton Malkiel suggests adhering to three rules:
Rule #1: Only Invest in Companies With Above-Average Expected Earnings for Five Years or More
When it comes to investing, earnings growth is the key marker of success: Not only will a high-growth company reward your stake with increasingly generous dividends, its price-earnings multiple may rise as well (thereby increasing the value of your initial stake). Also, the longer the growth continues, the more your investment compounds in value.
Rule #2: Only Pay What a Stock Is Really Worth
Although the “true” or “correct” value of a stock is ultimately impossible to determine—because present values take into account future earnings, which cannot be predicted with certainty—it is possible to tell whether a stock’s price is within reason. The way to do this is to compare a stock’s P/E multiple with the market’s multiple as a whole. If a growth stock’s multiple is more or less in line with the market’s, then that’s probably a promising stock to invest in.
The danger with this strategy comes when a promising stock’s P/E multiple already reflects its future revenue growth—that is, when you have to pay a premium for the stock which, to some extent, offsets the growth. The solution is to buy growth stocks with P/E multiples at or around the market’s. That way you increase the odds of the “double bonus” described just above: You receive the benefits of the earnings growth as well as the increase in the P/E multiple.
Rule #3: Be on the Lookout for Castles in the Air
Market enthusiasm, though it often leads to devastating bubbles, can also be used to the savvy investor’s advantage. If you discover a stock that has sound fundamentals as well as a compelling story—that is, one that is likely to produce steady returns while simultaneously attracting the interest of speculators—then that’s a stock worth considering.
To identify a “castle in the air” stock, simply think about whether the “story” of the stock could catch fire—for example, if the company has invented a new technology or its CEO has an impressive background or CV. Another simple way to pick a castle in the air is to see which stocks are beginning an uptrend.
Technical vs Fundamental Analysis
The following advice is from economist and author of A Random Walk Down Wall Street, Burton Malkiel.
Although Wall Street professionals today continue to use these methods of security analysis, the empirical evidence indicates that neither is a particularly reliable way to make investment decisions. This is the key to understanding technical vs fundamental analysis.
Regarding technical analysis, the key finding among researchers is that a stock’s past performance is no indication of its future performance. (In fact, stocks’ price movements resemble a “random walk” that’s similar to the results of flipping a coin.) Any method of analysis that relies on stocks’ “momentum”—whether a stock is generally moving either up or down—is sure to prove faulty.
Regarding fundamental analysis, no matter how lucid and well-founded a fundamentalist’s value determination is, he or she simply cannot account for randomness—the appearance of a groundbreaking technology, a new legal regime, or a catastrophic event like a public-health or environmental emergency. Fundamentalists can also make random mistakes in their analysis that result in bad bets.
There’s also the problem of bad actors. Firms can fudge their earnings reports, leading fundamental analysts astray. And fundamentalists’ reports can be unduly influenced by their own employer’s clients, resulting in conflicts of interest in their buy or sell recommendations.
This exploration of technical vs fundamental analysis will help you better understand the two concepts, and the recommended approach to security analysis.
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