The principles and philosophy behind technical analysis is from observations of past price movements of the stock market and individual shares. This is in sharp contrast to the fundamental analysis, which involves making investment decisions based on the examination of the economy, industry, and company variables that lead to an estimate of value for an investment which is then compared to the prevailing market price of the investment. Let us understand what technical and fundamental analyses are and how to use the same during the stock selection process.
Logic behind technical analysis
In technical analysis, there is no need to study the multitude of economic, industry, and company variables to arrive at an estimate of future value because they believe that past price movements will signal future price movements. It is also believed that a change in the price trend may predict a forthcoming change in the fundamental variables such as earnings and risk before the change is assessed through fundamental analysis.
Advantages of technical analysis The most important application of technical analysis is not to attempt to predict future prices but to evaluate the strength of ongoing trends and more particularly to help the investors to adapt to trends that are changing direction.
The fundamental analysis is based on the evaluation of financial statements to project future return and risk characteristics. But many psychological factors and other non-quantifiable variables do not appear in financial statements. These include employee training and loyalty, customer goodwill, and general investor attitude towards an industry. Investor attitudes could be important when investors become concerned about the risk from restrictions or taxes on products such as tobacco or alcohol or when firms do business in countries that have significant political risk.
Technical analysis uses data such as stock prices, volume of trading, and other trading information, derived from the stock market which already considered the non-quantifiable factors.
Let us suppose that through fundamental analysis, we have identified a share is undervalued or overvalued a long time before other investors. Still you must decide when to buy or sell. The highest rate of return would come from making the transaction just before the change in market value occurs. Assume that based on your analysis in February, you expect company ABC to report substantially higher earnings in June.
Although you could buy the stock in February, you would be better off waiting until about May to buy the stock so your funds would not be tied up for an extra three months, but you may be reticent to wait that long. But through technical analysis, you invest only when price move to the new equilibrium. Hence, by using technical analysis, you are more likely to experience ideal timing compared to the fundamental analysis.
Challenges to technical analysis
Many technical analysis tools are post-the-event and are hard to repeat. Both breakouts and resistance are reasonably correct in the short term but are very hard to repeat in the future. In fact, if you were to take most rules from technical analysis and consistently apply them on historical data, you would find that very few of them actually work. In contrast, there are fundamental principles that one can consistently apply over the long run and expect to do well. For example, companies with strong sales figures, increasing profit margin, consistent operating cash flow and solid management have done well and will continue to do so.
Which one to use?
Whether you want to base your investment decisions on fundamental analysis or technical analysis, you should be aware of the principles and practice of both. Majority of the long-term investors often shun technical analysis because it is thought to be a tool used solely for short-term speculation.
For many decades, fundamental analysis was the only investment method which was given higher order of credibility. But that has changed owing to the advent of high-speed computing tools, which has made technical analysis easier and more widely available.
Whether you like it or not, the best approach to investing should involve some combination of fundamental and technical analysis. So, choose stocks or sectors that have strong fundamentals and then use technical analysis to decide when to buy or sell them.
In technical analysis, there is no need to study the multitude of economic, industry, and company variables to arrive at an estimate of future value.
The most important application of technical analysis is to evaluate the strength of ongoing trends and to help the investors to adapt to these.
The fundamental analysis is based on evaluation of financial statements to project future return and risk characteristics.
Majority of the long-term investors often shun technical analysis because it is thought to be a tool used solely for short-term speculation
The writer is associate professor of finance & accounting in IIM, Shillong