Technical analysis and fundamental analysis are the two main methods for selecting shares. Which one is the better method is often hotly discussed. Technical analysis forecasts future price movements based on past price movements. Fundamental analysis on the other hand, looks at the financial figures, not just of the individual companies but also of the competitors, the customers and the whole economy. The goal is to find companies that are valued below their intrinsic value. A technical analyst on the other hand studies charts, trying to find buy or sell signals.
As can been seen already from the short introduction, the two methods don’t have much in common. The technical analyst is looking at historic prices, without even worrying about the underlying company. Actually, technical analysis can be used for anything that is traded, for example commodities and currencies, not just shares. Fundamental analysis is performed on historical and present data, as well as trying to estimate future figures.
Both methods have plenty of devoted followers, and hot debates are common about which school is the best. Especially some of the technical analysts defend their methods aggressively. This may have to do with that some people are looking down of technical analysis and ridicule it and its followers.
Technical analysis has become much easier thanks to cheap computers and Internet. With suitable software, it is possible to automatically download the latest information and display graphs on the screen. It is even possible to let the program do the buying and selling decisions automatically. In the good old days, technical analysts spent a lot of time collecting data and drawing graphs.
But does technical analysis (TA) work? There are plenty of stories about the efficiency of TA, both negative and positive. But it is difficult to find any studies that confirm that TA can be used to produce better returns than the market average. Every now and then a report pops about a new TA method that can be used to make money. But generally it turns out that someone has gone through an enormous amount of data, looking for patterns and found a way that would have produced a handsome profit. The problem is just that there is no guarantee that the specific pattern will repeat itself. By going through a lot of a data, looking at it from different angles, it is always possible to find some interesting patterns. This is true regardless if the data examined is just randomly generated or historic share prices.
Maybe the biggest concern about TA comes the fact that it is very difficult to find rich technical analysts. Given that thanks to computers and Internet, TA is very simple, shouldn’t plenty of people be making big profits? Apart from times when stock markets are going only upwards or downwards, it looks like technical analysts have trouble making money.
But wait a minute! Don’t hedge funds use technical analysis for some of their short term trading? Yes, hedge funds and other financial institutions often use TA for their short term trading. But they typically place huge money on relatively safe bets. The profit margins are extremely small, but with big money, even trades with razor thin profit margins add up to significant amounts after a while. Very few individual traders have such amounts of money and the trading fees are higher for individuals than for financial institutions. Even small fees will quickly wipe out any such small profits. Not to mention that hedge funds have invested enormous amounts of money to get the most efficient trading systems. A laptop with trading software for $100 is unlikely to outsmart such competition.
In theory, fundamental analysis seems to be almost foolproof. You buy something below its real value and wait until the market realizes the true value. Unfortunately, while TA is very simple thanks to computers, fundamental analysis is far from easy. First, there are a lot of different ways to estimate the intrinsic value of a company. Additionally, a number of forecasts about the future is necessary. Furthermore, a fundamental analyst must be able not only to read financial reports but also to understand what the figures are really saying. Even worse, a good understanding of the market is also necessary, as well as be able to judge the strength of competitors. In other words, in order to become a good fundamental analyst a lot of experience is necessary.
Does fundamental analysis work? Difficult question! There are certainly plenty of successful fundamental analysts. Unfortunately, since fundamental analysis can be done in many different ways and it requires a lot of training, it is far from guaranteed that fundamental analysts will be successful.
If you are going to become a trader, TA is the easiest method. But be careful, most traders seem to be losing money. For long term investments, thorough fundamental analysis is the best solution. Unfortunately, while TA just requires a computer with relatively cheap trading software and an Internet connection, fundamental analysis requires much more of the investor. Maybe cheap index funds are not that bad after all!