Fundamental vs. Technical Financial Analysis.Fundamental and Technical Financial Analysis

Fundamental and Technical Financial Analysis are two distinct approaches used by investors to evaluate securities and make informed decisions in the financial markets. Fundamental analysis focuses on assessing a security's intrinsic value by examining economic, financial, and qualitative factors, including macroeconomic conditions and a company's individual financial health. This method is generally favored by long-term investors seeking solid growth and income potential.

In contrast, technical analysis relies on market data, such as price charts and trading volume, to predict future market trends, often emphasizing short-term movements. Technical analysts believe that historical price patterns can help forecast future stock prices, allowing them to time market entries and exits effectively.

Both approaches have their strengths: fundamental analysis can provide insights into the long-term viability of investments, while technical analysis offers valuable data on market sentiment and trends. Investors may choose one method over the other depending on their goals, risk tolerance, and investment strategies, and many find value in combining elements of both analyses for a more comprehensive investment approach. Understanding these methods is crucial for making informed investment choices and navigating the complexities of financial markets.

Published in: 2021

By: Gould, Marie

Subject Terms

Fundamental and Technical Financial Analysis

Abstract

This article will focus on the decision making process for investing. There will be a special emphasis on comparing and contrasting fundamental and technical financial analysis. The success of the financial market is important to everyone across the world. If the market is not healthy, there is potential for crises. It has been suggested that most Americans do not know how to save or prepare for their future. As a result, many financial investment companies have approached employers as well as individuals in an attempt to educate the masses on the benefits of investing. When one is analyzing the financial market, he/she has the option of using one of two approaches. Fundamental and technical analyses are two types of analysis, but they have different approaches in terms of whether or not to trade or invest in financial markets.

Keywords Capital Asset Pricing Model (CAPM); Compounding; Day Trading; Financial Markets; Fundamental Analysis; Investments; Stock Market; Technical Analysis; Trading

Finance > Fundamental vs. Technical Financial Analysis

Overview

The success of the financial market is important to everyone across the world. "We live in a world that is shaped by financial markets and we are profoundly affected by their operation. Our employment prospects, our financial security, our pensions, the stability of political systems and nature of the society we live in are all greatly influenced by the operations of these markets" (Fenton-O'Creevy, Nicholson, Soane, & Willman, 2005, p. 1-2). If the market is not healthy, there is potential for crises.

It has been suggested that most Americans do not know how to save or prepare for their future. As a result, many financial investment companies have approached employers as well as individuals in an attempt to educate the masses on the benefits of investing. Some of the tips that have been provided by organizations, such as the American Association of Individual Investors, include:

Build and maintain a cash reserve to meet short-term emergencies and other liquidity needs.
Develop an overall investment strategy even if it cannot be implemented immediately.
Select mutual funds that fit into the overall investment strategy, then consider what the minimum initial investments are.
Select a balanced fund for less aggressive investors or a broad base index fund for more aggressive investors. Build the portfolio after this initial investment has been completed.
Review the percentage commitment to each stock market segment in order to determine when to add funds to the initial investment.
Do not agonize over small deviations from the original allocation plan. Stay the course! (p. 1-2).

When one is analyzing the financial market, he/she has the option of using one of two approaches. Fundamental and technical analyses are two types of analysis, but they have different approaches in terms of whether or not to trade or invest in financial markets. Overall, the process focuses on how to select markets and tools in order to trade or invest and time when it is appropriate to open and close trades or investments in order to maximize returns.

Definitions: Technical Analysis vs. Fundamental Analysis

According to investorwords.com, technical analysis is defined as:

A method in which to evaluate securities by relying on the assumption that market data (i.e. charts of price, volume, and open interest) may assist in predicting future (usually short-term) market trends. Unlike fundamental analysis, the intrinsic value of the security is not considered. Technical analysts believe that they can accurately predict the future price of a stock by looking at its historical prices and other trading variables. Technical analysis makes the assumption that market psychology influences trading in a manner that allows an analyst to predict when a stock will rise or fall. For that reason, many technical analysts are also market timers. Market timers believe that technical analysis can be applied just as easily to the market as a whole as to an individual stock.

According to Investopedia.com, fundamental analysis is defined as:

A method in which to evaluate a security by attempting to measure its intrinsic value by examining related economic, financial and other qualitative and quantitative factors. Fundamental analysts study those things that may affect the security's value, including macroeconomic factors (i.e. the overall economy and industry conditions) and individually specific factors (i.e. financial condition and management of companies). For example, the goal of fundamental analysis is to identify a value that an investor can compare with the security's current price with the expectation of determining what position to take with that specific security.

Choosing an Approach

Which is better? Both types of analysts have been successful in the designated fields. Many studies have been undertaken to determine which approach is better and to delineate the merits of each approach (Kaouther, 2013). The "right" answer depends on what the investor is interested in. For example a long-term investor looking for companies with a solid base, growth and income potential may be interested in the fundamental approach. However, there have been scenarios where a long term investor was not concerned about one company's basics because of plans to diversify in order to minimize risk or a short term investor waiting for investor sentiment to change. These types of investors would probably support the technical approach. Given the strengths of both approaches, many investors tend to find benefits from each type of analysis. Technical analysts can provide information on the broad market and its trends (macro level) but do not take into consideration the context of current economic and world events which some consider to be a weakness of this approach (Field, 2013). Fundamental analysts, however, can assist an investor in determining whether or not an issue has the basics in order to meet the investor's needs (micro level). In order to get a glimpse of the "big picture," it may be beneficial to take the best from both approaches.

Application

Compare & Contrast

The question of which approach is better will probably never be answered given the explanation listed above. Also, "there is little agreement on the supremacy of one approach because the success of a trader's system is so dependent on the individual characteristics of each trader" (Talati, 2002, p. 58). Let's explore the characteristics of both approaches.

Viewpoint

Capital Asset Pricing Model (CAPM)

In order to select investments for a portfolio, modern portfolio theory will use the capital asset pricing model ("What is modern…," 2007). The capital asset pricing model (CAPM) is utilized to calculate a theoretical price for a potential investment, and is a linear relationship between the returns of the shares and the stock market returns over time. The model analyzes the risk and return trade-off of individual assets to market returns. It can be used to:

Establish the desired equilibrium market price of a company's shares.
Establish the cost of a company's equity, which takes into account the risk characteristics of a company's investments.

There will always be some type of risk associated with an investment portfolio. The degree of risk can fluctuate between industries as well as between companies. A portfolio's risk is divided into two categories: Systematic and unsystematic risk.

Systematic risk refers to investments that are naturally riskier than others
Unsystematic risk refers to when the amount of risk can be minimized through diversification of the investments.

CAPM Assumptions

The CAPM operates on a set of assumptions such as:

Investors are risk averse individuals who maximize the expected utility of their end of period wealth, which implies that the model is a one period model.
Investors have homogenous expectations about asset returns, which indicate that all of the investors perceive themselves to have the same opportunity sets.
Asset returns are distributed by the normal distribution.
A risk free asset exists and investors may borrow or lend unlimited amounts of this asset at a constant rate, which is the risk free rate.
There are definite numbers of assets and their quantities are fixed within the one period model.
All assets are perfectly divisible and priced in a perfectly competitive market.
Asset markets are frictionless and information is costless and simultaneously available to all investors.
There are no market imperfections such as taxes, regulations, or restrictions on short selling ("CAPM — …," 2007)

In addition, the CAPM includes the following propositions:

Investors in shares require a return in excess of the risk free rate, to compensate for the systematic risk.
Investors should not require a premium for unsystematic risk because it can be diversified away by holding a wide portfolio of investments.
Since systematic risk varies between companies, investors will require a higher return from shares in those companies where the systematic risk is greater.

The same propositions can be applied to capital investment by companies:

Companies expect a return on a project to exceed the risk free rate so that they can be compensated for the systematic risk.
Unsystematic risk can be diversified away, which implies that a premium for unsystematic risk is not required.
Companies should strive for a bigger return on projects when the systematic risk is greater.

Disadvantages of the CAPM

There are some disadvantages to the CAPM, which include:

The model assumes that asset returns are normally distributed random variables. However, it has been observed that returns in equity and other markets are not normally distributed, which results in large swings in the market.
The model assumes that the variance of returns is an adequate measurement of risk.
The model does not appear to adequately explain the variation in stock returns.
The model assumes that given a certain expected return, investors will prefer lower risk to higher risk.
The model assumes that all investors have access to the same information and agree about the risk and expected return of all assets (Smith & Harvey, 2011).
The model assumes that there are no taxes or transaction costs. However, this assumption may be relaxed with more complicated versions of the model.
The market portfolio consists of all assets in all markets where each asset is weighted by its market capitalization.
The market portfolio should in theory include all types of assets that are held by anyone as an investment and people usually substitute a stock index as a proxy for the true market portfolio.
Since CAPM prices a stock in terms of all stocks and bonds, it is really an arbitrage pricing model which throws no light on how a firm's beta is determined.

Conclusion

Financial markets can be seen as an economics term because it highlights how individuals buy and sell financial securities, commodities and other items at low transaction costs and prices that reflect efficient markets. The overall objective of the process is to gather all of the sellers and put them in one place so that they can meet and interact with potential buyers. The goal is to create a process that will make it easy for the two groups to conduct business.

When one is analyzing the financial market, an investor has the option of using one of two approaches. Fundamental and technical analyses are two types of analysis, but they have different approaches in terms of whether or not to trade or invest in financial markets. Overall, the process focuses on how to select markets and tools to trade or invest and the time when it is appropriate to open and close trades or investments in order to maximize returns.

Which is better? Both types of analysts have been successful in the designated fields. The "right" answer depends on what the investor is interested in. For example a long-term investor looking for companies with a solid base, growth and income potential may be interested in the fundamental approach. However, there have been scenarios where a long term investor was not concerned about one company's basics because of plans to diversify in order to minimize risk or when a short term investor is waiting for investor sentiment to change. These types of investors would probably support the technical approach. Given the strengths of both approaches, many investors tend to find benefits from each type of analysis. Technical analysts can provide information on the broad market and its trends (macro level), whereas, fundamental analysts can assist an investor in determining whether or not an issue has the basics in order to meet the investor's needs (micro level). In order to get a glimpse of the "big picture," it may be beneficial to take the best from both approaches.

Terms & Concepts

Capital Asset Pricing Model (CAPM): A model used in finance to determine a theoretically appropriate required rate of return (and thus the price if expected cash flows can be estimated) of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk.

Compounding: Asserts that an investor can take a small amount of money and watch it grow into a substantial amount over time.

Day Trading: The purchase and sale (or short sale and purchase) of the same security on the same day in a single account.

Financial Markets: A market for the exchange of capital and credit, including the money markets and the capital markets.

Fundamental Analysis: A method in which to evaluate a security by attempting to measure its intrinsic value by examining related economic, financial and other qualitative and quantitative factors.

Investments: The act of investing; laying out money or capital in an enterprise with the expectation of profit.

Stock Market: The business transacted at a stock exchange.

Technical Analysis: A method in which to evaluate securities by relying on the assumption that market data (i.e. charts of price, volume, and open interest) may assist in predicting future (usually short-term) market trends.

Trading: Buying and selling securities or commodities on a short-term basis, hoping to make quick profits.

Table 1: Characteristics

Legend for Chart: A - Fundamental Approach B - Vs. C - Technical Approach A B C Concerned with why prices will move Vs. Concerned with when prices will move Rational, cause and effect Vs. Challenging, less risk adverse Long term Vs. Short and long term Grains and meats are common markets Vs. Currencies and financials are common markets. Power of Compounding is helpful. Time is seen as the greatest influence on one's investment portfolio. The power of compounding asserts that an investor can take a small amount of money and watch it grow into a substantial amount over time. Investments have the ability to increase in value over time. As time goes by, the value becomes greater. However, this can only occur if the investor continues to reinvest the returns. Vs. Stock Market Volatility is helpful. Volatility can be described in terms of points and percentages. Percentage volatility reflects percentage changes in the value of the amount invested. It is therefore useful to talk about percentage changes to discuss the change in a given investor's wealth or the change in wealth invested in the market, or in the economy as a whole. As a market's base level increases, the point volatility could increase while the percentage volatility could decrease. Longer term investing with mutual fund managers like Peter Lynch or John Bogle. Vs. Day Trading is entering and exiting a stock, options or other trading position in the same trading day. Make money out of your stake in companies and how their products or services sell Vs. Make money out of movement from the market with each movement often measured in pennies. How traders see investors — mature nurturer Vs. How investors see traders - risk taker Many take this path when the investor has a desire to grow rich slowly. However, depending on how the portfolio is set up; growth can actually be achieved quicker than expected. The approach often involves the "buy and hold" and longer term investing strategies. Vs. The investor relies heavily on market timing rules. This type of investor may participate in a get rich quickly scheme; work on his/her own terms and tends to make quick decisions that may not be well thought out. Unfortunately, this type of investor may lose everything if they do not know what they are doing.

Bibliography

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