Technical or Fundamental Analysis

Technical and Fundamental Analysis

When beginning to save, many people find themselves in-between either using technical or fundamental analysis for making their investment decisions. In the following article we will look into the differences between technical and fundamental analysis, and the approaches behind them.

In the market, you will find two types of individuals who follow either aspect of analysis. The first is the trader, who relies on technical and statistical analysis for the basis of short-term trades. The other is the investor, who uses fundamental valuation metrics to enter long-term positions that are unaffected by the current market price.  We will also be looking at the different operations of these individuals in this article.

Technical Analysis

Technical analysis uses the historical prices and volume of a certain stock to build a statistical model. A historical price measure that is commonly used is the Moving Average, which takes the past prices from a certain timeframe and averages it to a single plot point. These single plot points are made into a line, and the use of different timeframes can help traders create a clear understanding of potential support prices (a price where a stock may not fall below) and resistance prices (a price where a stock may not go above). Other statistical approaches that can be used are the standard deviation, Exponential Moving Average, Relative Strength Index and Moving Average Convergence Divergence. Here is an example of a chart, which shows the open, close, high and low prices of each day, with the Moving Averages for 50 days and 200 days overlaid on top.

Traders who use this type of analysis usually face much higher risk than a traditional investor. If they utilize derivatives, the cost of trading alone will be much higher and this will require them to generate higher returns just to breakeven.  Derivatives also carry a time-constraint, which forces the traders to make an assumption on the future of the market unlike investors who can wait until the market readjusts its valuation. Additionally, if they purchase, sell and repurchase the same stock in the short-term for losses, they may not be able to claim their losses for tax purposes because they will be accounted as superficial losses. There are many more downsides in operating as a trader, compared to an investor, but the upside is significant if the trader can correctly predict the movement of a stock.

Fundamental Analysis

Fundamental analysis is the complete opposite of technical analysis. By using fundamental analysis, you completely ignore what the market activity is suggesting and look at the underlying value of the business itself. This includes qualitative analysis of the industry, management and macro-economic factors, and also the quantitative analysis of the business. The quantitative analysis of a business is done through analyzing the four financial statements of a company and taking the figures from these statements to develop pricing models. One pricing model that can be used is the market multiples method (Price to Earnings, Price to Book, etc.), which shows how much you will be paying for each metric by purchasing the stock at current market prices. Another common pricing model is the discounted cash flow model, which takes the future cash flows of a business, discounts them for the present value and breaks it down to each share.  This type of analysis gives investors the ability to find an intrinsic value under the current market price and make a long-term position based off the valuation.

The benefits of investing over trading are that you do not have to manage your account every day, you can generate a greater return for much less risk, you can earn income from dividend payments and the tax benefits are in your favour.  The tax benefits include dividend tax credits and the higher likelihood that you can claim losses once you have exited an unprofitable position.  The returns generated from fundamental investing has been proven to outperform, and some of the greatest investors, such as Warren Buffet, completely rely on fundamental analysis and pay no attention to  market movements. There is a downside to this method compared to technical trading, because if you require capital in the short-term and there is a market correction or your stock is performing poorly, you may end up in an insolvent position or you may require exiting the position with large losses.