If you are interested to invest in stocks, it is necessary to understand the two major stock-picking methodologies used by common investors and analysts. Although these two main methodologies may seem to differ greatly, both of its objectives serve to provide some guidelines in making the best decision in stock trading. At the end of this article, you will be able to identify the main differences between fundamental and technical analysis and how these methodologies affect your investment decisions.
Fundamental Analysis
Fundamental analysis examines stock by determining its intrinsic value. It focuses on the underlying factors that could affect a company’s financial performance as well as the company’s future growth potentials. It stresses on the foundation and the building blocks of a company’s business. It entails the broader scope of macro and micro economic factors such as the industry-specific conditions as well as the narrower aspect of the company-specific factors such as financial stability and management team of the company. The fundamentalists start by scrutinizing the financials found in the financial statements of a company, balance sheet, income statement and cash flow statements. It then combines it with the underlying factors in order to try and derive the intrinsic value of a company. If the stock of a company is selling at a price that is below its intrinsic value and the company is of good fundamentals, then the stock is deemed to be an undervalued stock. These results in the stocks being a good buy and vice versa.
Technical Analysis
Technical analysis on the other hand disregards all areas of focus in the fundamental analysis. It is based on the assumption that at any point in time, the stock prices reflects all known factors that will affect the future of a company. Therefore, it is immaterial to study the fundamentals. Instead, the technical analyst, or chartist, will concentrate on information like the actual daily, weekly and monthly price fluctuations and trading volume in their bid to identify the future course of price movements. By looking at price and trading volume charts on market activities, technical analyst will try to identify the pattern and trend that will suggest the future direction of the stock prices. As the name chartist suggests, technical analysts utilize mathematical calculations and charts to monitor the market activities. From here, they make their trading decisions.
Here are the primary differences between the two:
The major criticism of technical analysis is that since all the past information has already been reflected in the stock price, analyzing past data will not bring any meaningful insights to the future price movement. Some even think that the effectiveness of technical analysis can be affected by crowd effects and a negative attitude. When many traders make buy decision based on the same technical chart of one company, this mass action will push the stock price up and thus reinforce the idea that the technical rules work.
In the case of fundamental analysis, many assumptions and estimates have to be made for the unknowns in the process of deriving the intrinsic value of a company. Therefore, there is no accurate answer for the intrinsic value as no two persons will have the same value derived. Even if the derived intrinsic value is closed enough to the ‘true’ value (the actual value of a company), it remains unclear as to how long the stock price will need to take to reflect that value.
© Securities Industry Development Corporation 2010. For more information on wise investing, log on to Malaysian Investor (www.min.com.my
© Securities Industry Development Corporation 2010. For more information on wise investing, log on to Malaysian Investor (www.min.com.my
Be that as it may, both methods have been utilised ever so often by many. Both have their own strong advocates as well as critics. At the end of the day, we should know what is closest to our own investment principle. Therefore, it boils back to us, as investors, to at least understand how these two methodologies function so we can aptly apply it to make the best investment decision.
